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In the foreword to Human Action: A Treatise on Economics, Mises explains complex market phenomena as “the outcomes of countless conscious, purposive actions, choices, and preferences of individuals, each of whom was trying as best as he or she could under the circumstances to attain various wants and ends and to avoid undesired consequences.” It is individual choices in response to personal subjective value judgments that ultimately determine market phenomena—supply and demand, prices, the pattern of production, and even profits and losses. Although governments may presume to set “prices,” it is individuals who, by their actions and choices through competitive bidding for money, products, and services, actually determine “prices”. Thus, Mises presents economics—not as a study of material goods, services, and products—but as a study of human actions. He sees the science of human action, praxeology, as a science of reason and logic, which recognizes a regularity in the sequence and interrelationships among market phenomena. Mises defends the methodology of praxeology against the criticisms of Marxists, socialists, positivists, and mathematical statisticians. Mises attributes the tremendous technological progress and the consequent increase in wealth and general welfare in the last two centuries to the introduction of liberal government policies based on free-market economic teachings, creating an economic and political environment which permits individuals to pursue their respective goals in freedom and peace. Mises also explains the futility and counter-productiveness of government attempts to regulate, control, and equalize all people’s circumstances: “Men are born unequal and … it is precisely their inequality that generates social cooperation and civilization.”

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Theory and History: An Interpretation of Social and Economic Evolution

Liberalism: The Classical Tradition

Human Action: A Treatise on Economics

The Ultimate Foundation of Economic Science

Nation, State, and Economy: Contributions to the Politics and History of Our Time

Edition: current; Page: [iii]

ludwig von mises

Edition: current; Page: [iv]Edition: current; Page: [v]

Human Action

The Treatise on Economics

LUDWIG VON MISES

Edited by Bettina Bien Greaves

Volume 2

liberty fund

Indianapolis

Edition: current; Page: [vi]

This book is published by Liberty Fund Inc., a foundation established to encourage study of the ideal of a society of free and responsible individuals.

The cuneiform inscription that serves as our logo and as the design motif for our endpapers is the earliest-known written appearance of the word “freedom” (amagi), or “liberty.” It is taken from a clay document written about 2300 bc in the Sumerian city-state of Lagash.

First published in 1949 by Yale University Press with a revised edition in 1963. In 1966, Henry Regnery Company published the third revised edition in agreement with Yale. The fourth revised edition (and the edition used for this setting) was published in 1996 by The Foundation for Economic Education, Inc. in cooperation with Bettina Bien Greaves.

HUMAN ACTION A Treatise on Economics
Volume 2

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PART 4: Catallactics or Economics of the Market Society

CHAPTER 14: The Scope and Method of Catallactics

1: The Delimitation of Catallactic Problems

There have never been any doubts and uncertainties about the scope of economic science. Ever since people have been eager for a systematic study of economics or political economy, all have agreed that it is the task of this branch of knowledge to investigate the market phenomena, that is, the determination of the mutual exchange ratios of the goods and services negotiated on markets, their origin in human action and their effects upon later action. The intricacy of a precise definition of the scope of economics does not stem from uncertainty with regard to the orbit of the phenomena to be investigated. It is due to the fact that the attempts to elucidate the phenomena concerned must go beyond the range of the market and of market transactions. In order to conceive the market fully one is forced to study the action of hypothetical isolated individuals on one hand and to contrast the market system with an imaginary socialist commonwealth on the other hand. In studying interpersonal exchange one cannot avoid dealing with autistic exchange. But then it is no longer possible to define neatly the boundaries between the kind of action which is the proper field of economic science in the narrower sense, and other action. Economics widens its horizon and turns into a general science of all and every human action, into praxeology. The question emerges of how to distinguish precisely, within the broader field of general praxeology, a narrower orbit of specifically economic problems.

The abortive attempts to solve this problem of a precise delimitation of the scope of catallactics have chosen as a criterion either the motives causing action or the goals which action aims at. But the variety and manifoldness of the motives instigating a man’s action are without relevance for a comprehensive study of acting. Every action is motivated by the urge to remove a felt uneasiness. It does not matter for the science of action how people qualify this uneasiness from a physiological, psychological, or ethical point of view. It is the task of economics to deal with all commodity prices as they are really asked and paid in market transactions. It must not restrict its investigations Edition: current; Page: [233] to the study of those prices which result or are likely to result from a conduct displaying attitudes to which psychology, ethics, or any other way of looking at human behavior would attach a definite label. The classification of actions according to their various motives may be momentous for psychology and may provide a yardstick for a moral evaluation; for economics it is inconsequential. Essentially the same is valid with regard to the endeavors to restrict the scope of economics to those actions which aim at supplying people with tangible material things of the external universe. Strictly speaking, people do not long for tangible goods as such, but for the services which these goods are fitted to render them. They want to attain the increment in well-being which these services are able to convey. But if this is so, it is not permissible to except from the orbit of “economic” action those actions which remove uneasiness directly without the interposition of any tangible and visible things. The advice of a doctor, the instruction of a teacher, the recital of an artist, and other personal services are no less objects of economic study than the architect’s plans for the construction of a building, the scientist’s formula for the production of a chemical compound, and the author’s contribution to the publishing of a book.

The subject matter of catallactics is all market phenomena with all their roots, ramifications, and consequences. It is a fact that people in dealing on the market are motivated not only by the desire to get food, shelter, and sexual enjoyment, but also by manifold “ideal” urges. Acting man is always concerned both with “material” and “ideal” things. He chooses between various alternatives, no matter whether they are to be classified as material or ideal. In the actual scales of value material and ideal things are jumbled together. Even if it were feasible to draw a sharp line between material and ideal concerns, one must realize that every concrete action either aims at the realization both of material and ideal ends or is the outcome of a choice between something material and something ideal.

Whether it is possible to separate neatly those actions which aim at the satisfaction of needs exclusively conditioned by man’s physiological constitution from other “higher” needs can be left undecided. But we must not overlook the fact that in reality no food is valued solely for its nutritive power and no garment or house solely for the protection it affords against cold weather and rain. It cannot be denied that the demand for goods is widely influenced by metaphysical, religious, and ethical considerations, by aesthetic value judgments, by customs, habits, prejudices, tradition, changing fashions, and many other things. To an economist who would try to restrict his investigations Edition: current; Page: [234] to “material” aspects only, the subject matter of inquiry vanishes as soon as he wants to catch it.

All that can be contended is this: Economics is mainly concerned with the analysis of the determination of money prices of goods and services exchanged on the market. In order to accomplish this task it must start from a comprehensive theory of human action. Moreover, it must study not only the market phenomena, but no less the hypothetical conduct of an isolated man and of a socialist community. Finally, it must not restrict its investigations to those modes of action which in mundane speech are called “economic” actions, but must deal also with actions which are in a loose manner of speech called “noneconomic.”

The scope of praxeology, the general theory of human action, can be precisely defined and circumscribed. The specifically economic problems, the problems of economic action in the narrower sense, can only by and large be disengaged from the comprehensive body of praxeological theory. Accidental facts of the history of science or conventions play a role in all attempts to provide a definition of the scope of “genuine” economics.

Not logical or epistemological rigor, but considerations of expediency and traditional convention make us declare that the field of catallactics or of economics in the narrower sense is the analysis of the market phenomena. This is tantamount to the statement: Catallactics is the analysis of those actions which are conducted on the basis of monetary calculation. Market exchange and monetary calculation are inseparably linked together. A market in which there is direct exchange only is merely an imaginary construction. On the other hand, money and monetary calculation are conditioned by the existence of the market.

It is certainly one of the tasks of economics to analyze the working of an imaginary socialist system of production. But access to this study too is possible only through the study of catallactics, the elucidation of a system in which there are money prices and economic calculation.

The Denial of Economics

There are doctrines flatly denying that there can be a science of economics. What is taught nowadays at most of the universities under the label of economics is practically a denial of it.

He who contests the existence of economics virtually denies that man’s well-being is disturbed by any scarcity of external factors. Everybody, he implies, could enjoy the perfect satisfaction of all his wishes, provided a reform succeeds in overcoming certain obstacles brought Edition: current; Page: [235] about by inappropriate man-made institutions. Nature is open-handed, it lavishly loads mankind with presents. Conditions could be paradisiac for an indefinite number of people. Scarcity is an artificial product of established practices. The abolition of such practices would result in abundance.

In the doctrine of Karl Marx and his followers scarcity is a historical category only. It is the feature of the primeval history of mankind which will be forever liquidated by the abolition of private property. Once mankind has effected the leap from the realm of necessity into the realm of freedom1 and thereby reached “the higher phase of communist society,” there will be abundance and consequently it will be feasible to give “to each according to his needs.”2 There is in the vast flood of Marxian writings not the slightest allusion to the possibility that a communist society in its “higher phase” might have to face a scarcity of natural factors of production. The fact of the disutility of labor is spirited away by the assertion that to work, under communism of course, will no longer be pain but pleasure, “the primary necessity of life.”3 The unpleasant experiences of the Russian “experiment” are interpreted as caused by the capitalists’ hostility, by the fact that socialism in one country only is not yet perfect and therefore has not yet been able to bring about the “higher phase,” and, more recently, by the war.

Then there are the radical inflationists as represented, for example, by Proudhon and by Ernest Solvay. In their opinion scarcity is created by the artificial checks upon credit expansion and other methods of increasing the quantity of money in circulation, enjoined upon the gullible public by the selfish class interests of bankers and other exploiters. They recommend unlimited public spending as the panacea.

Such is the myth of potential plenty and abundance. Economics may leave it to the historians and psychologists to explain the popularity of this kind of wishful thinking and indulgence in daydreams. All that economics has to say about such idle talk is that economics deals with the problems man has to face on account of the fact that his life is conditioned by natural factors. It deals with action, i.e., with the conscious endeavors to remove as far as possible felt uneasiness. It has nothing to assert with regard to the state of affairs in an unrealizable and for human reason even inconceivable universe of unlimited opportunities. In such a world, it may be admitted, there will be no law of value, no scarcity, and no economic problems. These things will be Edition: current; Page: [236] absent because there will be no choices to be made, no action, and no tasks to be solved by reason. Beings which would have thrived in such a world would never have developed reasoning and thinking. If ever such a world were to be given to the descendants of the human race, these blessed beings would see their power to think wither away and would cease to be human. For the primary task of reason is to cope consciously with the limitations imposed upon man by nature, is to fight against scarcity. Acting and thinking man is the product of a universe of scarcity in which whatever well-being can be attained is the prize of toil and trouble, of conduct popularly called economic.

2: The Method of Imaginary Constructions

The specific method of economics is the method of imaginary constructions.

This method is the method of praxeology. That it has been carefully elaborated and perfected in the field of economic studies in the narrower sense is due to the fact that economics, at least until now, has been the best-developed part of praxeology. Everyone who wants to express an opinion about the problems commonly called economic takes recourse to this method. The employment of these imaginary constructions is, to be sure, not a procedure peculiar to the scientific analysis of these problems. The layman in dealing with them resorts to the same method. But while the layman’s constructions are more or less confused and muddled, economics is intent upon elaborating them with the utmost care, scrupulousness, and precision, and upon examining their conditions and assumptions critically.

An imaginary construction is a conceptual image of a sequence of events logically evolved from the elements of action employed in its formation. It is a product of deduction, ultimately derived from the fundamental category of action, the act of preferring and setting aside. In designing such an imaginary construction the economist is not concerned with the question of whether or not it depicts the conditions of reality which he wants to analyze. Nor does he bother about the question of whether or not such a system as his imaginary construction posits could be conceived as really existent and in operation. Even imaginary constructions which are inconceivable, self-contradictory, or unrealizable can render useful, even indispensable services in the comprehension of reality, provided the economist knows how to use them properly.

The method of imaginary constructions is justified by its success. Praxeology cannot, like the natural sciences, base its teachings upon laboratory experiments and sensory perception of external objects. Edition: current; Page: [237] It had to develop methods entirely different from those of physics and biology. It would be a serious blunder to look for analogies to the imaginary constructions in the field of the natural sciences. The imaginary constructions of praxeology can never be confronted with any experience of things external and can never be appraised from the point of view of such experience. Their function is to serve man in a scrutiny which cannot rely upon his senses. In confronting the imaginary constructions with reality we cannot raise the question of whether they correspond to experience and depict adequately the empirical data. We must ask whether the assumptions of our construction are identical with the conditions of those actions which we want to conceive.

The main formula for designing of imaginary constructions is to abstract from the operation of some conditions present in actual action. Then we are in a position to grasp the hypothetical consequences of the absence of these conditions and to conceive the effects of their existence. Thus we conceive the category of action by constructing the image of a state in which there is no action, either because the individual is fully contented and does not feel any uneasiness or because he does not know any procedure from which an improvement in his well-being (state of satisfaction) could be expected. Thus we conceive the notion of originary interest from an imaginary construction in which no distinction is made between satisfactions in periods of time equal in length but unequal with regard to their distance from the instant of action.

The method of imaginary constructions is indispensable for praxeology; it is the only method of praxeological and economic inquiry. It is, to be sure, a method difficult to handle because it can easily result in fallacious syllogisms. It leads along a sharp edge; on both sides yawns the chasm of absurdity and nonsense. Only merciless self-criticism can prevent a man from falling headlong into these abysmal depths.

3: The Pure Market Economy

The imaginary construction of a pure or unhampered market economy assumes that there is division of labor and private ownership (control) of the means of production and that consequently there is market exchange of goods and services. It assumes that the operation of the market is not obstructed by institutional factors. It assumes that the government, the social apparatus of compulsion and coercion, is intent upon preserving the operation of the market system, abstains from hindering its functioning, and protects it against encroachments Edition: current; Page: [238] on the part of other people. The market is free; there is no interference of factors, foreign to the market, with prices, wage rates, and interest rates. Starting from these assumptions economics tries to elucidate the operation of a pure market economy. Only at a later stage, having exhausted everything which can be learned from the study of this imaginary construction, does it turn to the study of the various problems raised by interference with the market on the part of governments and other agencies employing coercion and compulsion.

It is amazing that this logically incontestable procedure, the only one that is fitted to solve the problems involved, has been passionately attacked. People have branded it as a prepossession in favor of a liberal economic policy, which they stigmatize as reactionary, economic royalism, Manchesterism, negativism, and so on. They deny that anything can be gained for the knowledge of reality from occupation with this imaginary construction. However, these turbulent critics contradict themselves as they take recourse to the same method in advancing their own assertions. In asking for minimum wage rates they depict the alleged unsatisfactory conditions of a free labor market and in asking for tariffs they describe the alleged disasters brought about by free trade. There is, of course, no other way available for the elucidation of a measure limiting the free play of the factors operating on an unhampered market than to study first the state of affairs prevailing under economic freedom.

It is true that economists have drawn from their investigations the conclusion that the goals which most people, practically even all people, are intent on attaining by toiling and working and by economic policy can best be realized where the free market system is not impeded by government decrees. But this is not a preconceived judgment stemming from an insufficient occupation with the operation of government interference with business. It is, on the contrary, the result of a careful unbiased scrutiny of all aspects of interventionism.

It is also true that the classical economists and their epigones used to call the system of the unhampered market economy “natural” and government meddling with market phenomena “artificial” and “disturbing.” But this terminology also was the product of their careful scrutiny of the problems of interventionism. They were in conformity with the semantic practice of their age in calling an undesirable state of social affairs “contrary to nature.”

Theism and Deism of the Age of Enlightenment viewed the regularity of natural phenomena as an emanation of the decrees of Providence. When the philosophers of the Enlightenment discovered that there prevails a regularity of phenomena also in human action and in social evolution, they were prepared to interpret it likewise as evidence Edition: current; Page: [239] of the paternal care of the Creator of the universe. This was the true meaning of the doctrine of the predetermined harmony as expounded by some economists.4 The social philosophy of paternal despotism laid stress upon the divine mission of kings and autocrats predestined to rule the peoples. The liberal retorted that the operation of an unhampered market, on which the consumer—i.e., every citizen—is sovereign, brings about more satisfactory results than the decrees of anointed rulers. Observe the functioning of the market system, they said, and you will discover in it too the finger of God.

Along with the imaginary construction of a pure market economy the classical economists elaborated its logical counterpart, the imaginary construction of a socialist commonwealth. In the heuristic process which finally led to the discovery of the operation of a market economy this image of a socialist order even had logical priority. The question which preoccupied the economists was whether a tailor could be supplied with bread and shoes if there was no government decree compelling the baker and the shoemaker to provide for his needs. The first thought was that authoritarian interference is required to make every specialist serve his fellow citizens. The economists were taken aback when they discovered that no such compulsion is needed. In contrasting productivity and profitability, self-interest and public welfare, selfishness and altruism, the economists implicitly referred to the image of a socialist system. Their astonishment at the “automatic,” as it were, steering of the market system was precisely due to the fact that they realized that an “anarchic” state of production results in supplying people better than the orders of a centralized omnipotent government. The idea of socialism—a system of the division of labor entirely controlled and managed by a planning authority—did not originate in the heads of utopian reformers. These utopians aimed rather at the autarkic coexistence of small self-sufficient bodies; take, for instance, Fourier’s phalanstère. The radicalism of the reformers turned toward socialism when they took the image of an economy managed by a national government or a world authority, implied in the theories of the economists, as a model for their new order.

The Maximization of Profits

It is generally believed that economists, in dealing with the problems of a market economy, are quite unrealistic in assuming that all Edition: current; Page: [240] men are always eager to gain the highest attainable advantage. They construct, it is said, the image of a perfectly selfish and rationalistic being for whom nothing counts but profit. Such a Homo oeconomicus [(Latin) economic man] may be a likeness of stock jobbers and speculators. But the immense majority are very different. Nothing for the cognition of reality can be learned from the study of the conduct of this delusive image.

It is not necessary to enter again into a refutation of all the confusion, error, and distortion inherent in this contention. The first two parts of this book have unmasked the fallacies implied. At this point it is enough to deal with the problem of the maximization of profits.

Praxeology in general and economics in its special field assume with regard to the springs of human action nothing other than that acting man wants to remove uneasiness. Under the particular conditions of dealing on the market, action means buying and selling. Everything that economics asserts about demand and supply refers to every instance of demand and supply and not only to demand and supply brought about by some special circumstances requiring a particular description or definition. To assert that a man, faced with the alternative of getting more or less for a commodity he wants to sell, ceteris paribus [(Latin) other things being equal] chooses the high price, does not require any further assumption. A higher price means for the seller a better satisfaction of his wants. The same applies mutatis mutandis [(Latin) with due alteration of details] to the buyer. The amount saved in buying the commodity concerned enables him to spend more for the satisfaction of other needs. To buy in the cheapest market and to sell in the dearest market is, other things being equal, not conduct which would presuppose any special assumptions concerning the actor’s motives and morality. It is merely the necessary offshoot of any action under the conditions of market exchange.

In his capacity as a businessman a man is a servant of the consumers, bound to comply with their wishes. He cannot indulge in his own whims and fancies. But his customers’ whims and fancies are for him ultimate law, provided these customers are ready to pay for them. He is under the necessity of adjusting his conduct to the demand of the consumers. If the consumers, without a taste for the beautiful, prefer things ugly and vulgar, he must, contrary to his own convictions, supply them with such things.5 If consumers do not want to pay a higher price for domestic products than for those produced abroad, he must buy the foreign product, provided it is cheaper. An employer cannot grant favors at the expense of his customers. He cannot pay wage rates higher than those determined by the market if the buyers are not ready to pay proportionately higher prices for Edition: current; Page: [241] commodities produced in plants in which wage rates are higher than in other plants.

It is different with man in his capacity as spender of his income. He is free to do what he likes best. He can bestow alms. He can, motivated by various doctrines and prejudices, discriminate against goods of a certain origin or source and prefer the worse or more expensive product to the—technologically—better and cheaper one.

As a rule people in buying do not make gifts to the seller. But nonetheless that happens. The boundaries between buying goods and services needed and giving alms are sometimes difficult to discern. He who buys at a charity sale usually combines a purchase with a donation for a charitable purpose. He who gives a dime to a blind street musician certainly does not pay for the questionable performance; he simply gives alms.

Man in acting is a unity. The businessman who owns the whole firm may sometimes efface the boundaries between business and charity. If he wants to relieve a distressed friend, delicacy of feeling may prompt him to resort to a procedure which spares the latter the embarrassment of living on alms. He gives the friend a job in his office although he does not need his help or could hire an equivalent helper at a lower salary. Then the salary granted appears formally as a part of business outlays. In fact it is the spending of a fraction of the businessman’s income. It is, from a correct point of view, consumption and not an expenditure designed to increase the firm’s profits.6

Awkward mistakes are due to the tendency to look only upon things tangible, visible, and measurable, and to neglect everything else. What the consumer buys is not simply food or calories. He does not want to feed like a wolf, he wants to eat like a man. Food satisfies the appetite of many people the better, the more appetizingly and tastefully it is prepared, the finer the table is set, and the more agreeable the environment is in which the food is consumed. Such things are regarded as of no consequence by a consideration exclusively occupied with the chemical aspects of the process of digestion.7 But the fact that they play an important role in the determination of food prices is perfectly compatible with the assertion that people prefer, ceteris paribus, to buy in the cheapest market. Whenever a buyer, in choosing between two things which chemists and technologists deem perfectly equal, prefers the more expensive, he has a reason. If he does not err, he Edition: current; Page: [242] pays for services which chemistry and technology cannot comprehend with their specific methods of investigation. If a man prefers an expensive place to a cheaper one because he likes to sip his cocktails in the neighborhood of a duke, we may remark on his ridiculous vanity. But we must not say that the man’s conduct does not aim at an improvement of his own state of satisfaction.

What a man does is always aimed at an improvement of his own state of satisfaction. In this sense—and in no other—we are free to use the term selfishness and to emphasize that action is necessarily always selfish. Even an action directly aiming at the improvement of other people’s conditions is selfish. The actor considers it as more satisfactory for himself to make other people eat than to eat himself. His uneasiness is caused by the awareness of the fact that other people are in want.

It is a fact that many people behave in another way and prefer to fill their own stomach and not that of their fellow citizens. But this has nothing to do with economics; it is a datum of historical experience. At any rate, economics refers to every kind of action, no matter whether motivated by the urge of a man to eat or to make other people eat.

If maximizing profits means that a man in all market transactions aims at increasing to the utmost the advantage derived, it is a pleonastic and periphrastic circumlocution. It only asserts what is implied in the very category of action. If it means anything else, it is the expression of an erroneous idea.

Some economists believe that it is the task of economics to establish how in the whole of society the greatest possible satisfaction of all people or of the greatest number could be attained. They do not realize that there is no method which would allow us to measure the state of satisfaction attained by various individuals. They misconstrue the character of judgments which are based on the comparison between various people’s happiness. While expressing arbitrary value judgments, they believe themselves to be establishing facts. One may call it just to rob the rich in order to make presents to the poor. However, to call something fair or unfair is always a subjective value judgment and as such purely personal and not liable to any verification or falsification. Economics is not intent upon pronouncing value judgments. It aims at a cognition of the consequences of certain modes of acting.

It has been asserted that the physiological needs of all men are of the same kind and that this equality provides a standard for the measurement of the degree of their objective satisfaction. In expressing such opinions and in recommending the use of such criteria to guide the government’s policy, one proposes to deal with men as the breeder deals with his cattle. But the reformers fail to realize that there is no Edition: current; Page: [243] universal principle of alimentation valid for all men. Which one of the various principles one chooses depends entirely on the aims one wants to attain. The cattle breeder does not feed his cows in order to make them happy, but in order to attain the ends which he has assigned to them in his own plans. He may prefer more milk or more meat or something else. What type of men do the man breeders want to rear—athletes or mathematicians? Warriors or factory hands? He who would make man the material of a purposeful system of breeding and feeding would arrogate to himself despotic powers and would use his fellow citizens as means for the attainment of his own ends, which differ from those they themselves are aiming at.

The value judgments of an individual differentiate between what makes him more satisfied and what less. The value judgments a man pronounces about another man’s satisfaction do not assert anything about this other man’s satisfaction. They only assert what condition of this other man better satisfies the man who pronounces the judgment. The reformers searching for the maximum of general satisfaction have told us merely what state of other people’s affairs would best suit themselves.

4: The Autistic Economy

No other imaginary construction has caused more offense than that of an isolated economic actor entirely dependent on himself. However, economics cannot do without it. In order to study interpersonal exchange it must compare it with conditions under which it is absent. It constructs two varieties of the image of an autistic economy in which there is only autistic exchange: the economy of an isolated individual and the economy of a socialist society. In employing this imaginary construction the economists do not bother about the problem of whether or not such a system could really work.8 They are fully aware of the fact that their imaginary construction is fictitious. Robinson Crusoe, who, for all that, may have existed, and the general manager of a perfectly isolated socialist commonwealth that never existed, would not have been in a position to plan and to act as people can only when taking recourse to economic calculation. However, in the frame of our imaginary construction we are free to pretend that they could calculate whenever such a fiction may be useful for the discussion of the specific problem to be dealt with.

The imaginary construction of an autistic economy is at the bottom of the popular distinction between productivity and profitability as it Edition: current; Page: [244] developed as a yardstick of value judgments. Those resorting to this distinction consider the autistic economy, especially that of the socialist type, the most desirable and most perfect system of economic management. Every phenomenon of the market economy is judged with regard to whether or not it could be justified from the viewpoint of a socialist system. Only to acting that would be purposeful in the plans of such a system’s manager are positive value and the epithet productive attached. All other activities performed in the market economy are called unproductive in spite of the fact that they may be profitable to those who perform them. Thus, for example, sales promotion, advertising, and banking are considered as activities profitable but nonproductive.

Economics, of course, has nothing to say about such arbitrary value judgments.

5: The State of Rest and the Evenly Rotating Economy

The only method of dealing with the problem of action is to conceive that action ultimately aims at bringing about a state of affairs in which there is no longer any action, whether because all uneasiness has been removed or because any further removal of felt uneasiness is out of the question. Action thus tends toward a state of rest, absence of action.

The theory of prices accordingly analyzes interpersonal exchange from this aspect. People keep on exchanging on the market until no further exchange is possible because no party expects any further improvement of its own conditions from a new act of exchange. The potential buyers consider the prices asked by the potential sellers unsatisfactory, and vice versa. No more transactions take place. A state of rest emerges. This state of rest, which we may call the plain state of rest, is not an imaginary construction. It comes to pass again and again. When the stock market closes, the brokers have carried out all orders which could be executed at the market price. Only those potential sellers and buyers who consider the market price too low or too high respectively have not sold or bought.9 The same is valid with regard to all transactions. The whole market economy is a big exchange or marketplace, as it were. At any instant all those transactions take place which the parties are ready to enter into at the realizable price. New sales can be effected only when the valuations of at least one of the parties have changed.

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It has been asserted that the notion of the plain state of rest is unsatisfactory. It refers, people have said, only to the determination of prices of goods of which a definite supply is already available, and does not say anything about the effects brought about by these prices upon production. The objection is unfounded. The theorems implied in the notion of the plain state of rest are valid with regard to all transactions without exception. It is true, the buyers of factors of production will immediately embark upon producing and very soon reenter the market in order to sell their products and to buy what they want for their own consumption and for continuing production processes. But this does not invalidate the scheme. This scheme, to be sure, does not contend that the state of rest will last. The lull will certainly disappear as soon as the momentary conditions which brought it about change.

The notion of the plain state of rest is not an imaginary construction but the adequate description of what happens again and again on every market. In this regard it differs radically from the imaginary construction of the final state of rest.

In dealing with the plain state of rest we look only at what is going on right now. We restrict our attention to what has happened momentarily and disregard what will happen later, in the next instant or tomorrow or later. We are dealing only with prices really paid in sales, i.e., with the prices of the immediate past. We do not ask whether or not future prices will equal these prices.

But now we go a step further. We pay attention to factors which are bound to bring about a tendency toward price changes. We try to find out to what goal this tendency must lead before all its driving force is exhausted and a new state of rest emerges. The price corresponding to this future state of rest was called the natural price by older economists; nowadays the term static price is often used. In order to avoid misleading associations it is more expedient to call it the final price and accordingly to speak of the final state of rest. This final state of rest is an imaginary construction, not a description of reality. For the final state of rest will never be attained. New disturbing factors will emerge before it will be realized. What makes it necessary to take recourse to this imaginary construction is the fact that the market at every instant is moving toward a final state of rest. Every later new instant can create new facts altering this final state of rest. But the market is always disquieted by a striving after a definite final state of rest.

The market price is a real phenomenon; it is the exchange ratio which was actual in business transacted. The final price is a hypothetical Edition: current; Page: [246] price. The market prices are historical facts and we are therefore in a position to note them with numerical exactitude in dollars and cents. The final price can only be defined by defining the conditions required for its emergence. No definite numerical value in monetary terms or in quantities of other goods can be attributed to it. It will never appear on the market. The market price can never coincide with the final price coordinated to the instant in which this market structure is actual. But catallactics would fail lamentably in its task of analyzing the problems of price determination if it were to neglect dealing with the final price. For in the market situation from which the market price emerges there are already latent forces operating which will go on bringing about price changes until, provided no new data appear, the final price and the final state of rest are established. We would unduly restrict our study of price determination if we were to look only upon the momentary market prices and the plain state of rest and to disregard the fact that the market is already agitated by factors which must result in further price changes and a tendency toward a different state of rest.

The phenomenon with which we have to cope is the fact that changes in the factors which determine the formation of prices do not produce all their effects at once. A span of time must elapse before all their effects are exhausted. Between the appearance of a new datum and the perfect adjustment of the market to it some time must pass. (And, of course, while this period of time elapses, other new data appear.) In dealing with the effects of any change in the factors operating on the market, we must never forget that we are dealing with events taking place in succession, with a series of effects succeeding one another. We are not in a position to know in advance how much time will have to elapse. But we know for certain that some time must elapse, although this period may sometimes be so small that it hardly plays any role in practical life.

Economists often erred in neglecting the element of time. Take for instance the controversy concerning the effects of changes in the quantity of money. Some people were only concerned with its long-run effects, i.e., with the final prices and the final state of rest. Others saw only the short-run effects, i.e., the prices of the instant following the change in the data. Both were mistaken and their conclusions were consequently vitiated. Many more examples of the same blunder could be cited.

The imaginary construction of the final state of rest is marked by paying full regard to change in the temporal succession of events. In this respect it differs from the imaginary construction of the evenlyEdition: current; Page: [247]rotating economy which is characterized by the elimination of change in the data and of the time element. (It is inexpedient and misleading to call this imaginary construction, as is usual, the static economy or the static equilibrium, and it is a bad mistake to confuse it with the imaginary construction of a stationary economy.10) The evenly rotating economy is a fictitious system in which the market prices of all goods and services coincide with the final prices. There are in its frame no price changes whatever; there is perfect price stability. The same market transactions are repeated again and again. The goods of the higher orders pass in the same quantities through the same stages of processing until ultimately the produced consumers’ goods come into the hands of the consumers and are consumed. No changes in the market data occur. Today does not differ from yesterday and tomorrow will not differ from today. The system is in perpetual flux, but it remains always at the same spot. It revolves evenly round a fixed center, it rotates evenly. The plain state of rest is disarranged again and again, but it is instantly reestablished at the previous level. All factors, including those bringing about the recurring disarrangement of the plain state of rest, are constant. Therefore prices—commonly called static or equilibrium prices—remain constant too.

The essence of this imaginary construction is the elimination of the lapse of time and of the perpetual change in the market phenomena. The notion of any change with regard to supply and demand is incompatible with this construction. Only such changes as do not affect the configuration of the price-determining factors can be considered in its frame. It is not necessary to people the imaginary world of the evenly rotating economy with immortal, non-aging and nonproliferating men. We are free to assume that infants are born, grow old, and finally die, provided that total population figures and the number of people in every age group remain equal. Then the demand for commodities whose consumption is limited to certain age groups does not alter, although the individuals from whom it originates are not the same.

In reality there is never such a thing as an evenly rotating economic system. However, in order to analyze the problems of change in the data and of unevenly and irregularly varying movement, we must confront them with a fictitious state in which both are hypothetically eliminated. It is therefore preposterous to maintain that the construction of an evenly rotating economy does not elucidate conditions within a changing universe and to require the economists to Edition: current; Page: [248] substitute a study of “dynamics” for their alleged exclusive occupation with “statics.” This so-called static method is precisely the proper mental tool for the examination of change. There is no means of studying the complex phenomena of action other than first to abstract from change altogether, then to introduce an isolated factor provoking change, and ultimately to analyze its effects under the assumption that other things remain equal. It is furthermore absurd to believe that the services rendered by the construction of an evenly rotating economy are the more valuable the more the object of our studies, the realm of real action, corresponds to this construction in respect to absence of change. The static method, the employment of the imaginary construction of an evenly rotating economy, is the only adequate method of analyzing the changes concerned without regard to whether they are great or small, sudden or slow.

The objections hitherto raised against the use of the imaginary construction of an evenly rotating economy missed the mark entirely. Their authors did not grasp in what respect this construction is problematic and why it can easily engender error and confusion.

Action is change, and change is in the temporal sequence. But in the evenly rotating economy change and succession of events are eliminated. Action is to make choices and to cope with an uncertain future. But in the evenly rotating economy there is no choosing and the future is not uncertain as it does not differ from the present known state. Such a rigid system is not peopled with living men making choices and liable to error; it is a world of soulless unthinking automatons; it is not a human society, it is an ant hill.

These insoluble contradictions, however, do not affect the service which this imaginary construction renders for the only problems for whose treatment it is both appropriate and indispensable: the problem of the relation between the prices of products and those of the factors required for their production, and the implied problems of entrepreneurship and of profit and loss. In order to grasp the function of entrepreneurship and the meaning of profit and loss, we construct a system from which they are absent. This image is merely a tool for our thinking. It is not the description of a possible and realizable state of affairs. It is even out of the question to carry the imaginary construction of an evenly rotating system to its ultimate logical consequences. For it is impossible to eliminate the entrepreneur from the picture of a market economy. The various complementary factors of production cannot come together spontaneously. They need to be combined by the purposive efforts of men aiming at certain ends and motivated by the urge to improve their state of Edition: current; Page: [249] satisfaction. In eliminating the entrepreneur one eliminates the driving force of the whole market system.

Then there is a second deficiency. In the imaginary construction of an evenly rotating economy, indirect exchange and the use of money are tacitly implied. But what kind of money can that be? In a system without change in which there is no uncertainty whatever about the future, nobody needs to hold cash. Every individual knows precisely what amount of money he will need at any future date. He is therefore in a position to lend all the funds he receives in such a way that the loans fall due on the date he will need them. Let us assume that there is only gold money and only one central bank. With the successive progress toward the state of an evenly rotating economy all individuals and firms restrict step by step their holding of cash and the quantities of gold thus released flow into nonmonetary—industrial—employment. When the equilibrium of the evenly rotating economy is finally reached, there are no more cash holdings; no more gold is used for monetary purposes. The individuals and firms own claims against the central bank, the maturity of each part of which precisely corresponds to the amount they will need on the respective dates for the settlement of their obligations. The central bank does not need any reserves as the total sum of the daily payments of its customers exactly equals the total sum of withdrawals. All transactions can in fact be effected through transfer in the bank’s books without any recourse to cash. Thus the “money” of this system is not a medium of exchange; it is not money at all; it is merely a numéraire, an ethereal and undetermined unit of accounting of that vague and indefinable character which the fancy of some economists and the errors of many laymen mistakenly have attributed to money. The interposition of these numerical expressions between seller and buyer does not affect the essence of the sales; it is neutral with regard to the people’s economic activities. But the notion of a neutral money is unrealizable and inconceivable in itself.11 If we were to use the inexpedient terminology employed in many contemporary economic writings, we would have to say: Money is necessarily a “dynamic factor”; there is no room left for money in a “static” system. But the very notion of a market economy without money is self-contradictory.

The imaginary construction of an evenly rotating system is a limiting notion. In its frame there is in fact no longer any action. Automatic reaction is substituted for the conscious striving of thinking man after the removal of uneasiness. We can employ this problematic Edition: current; Page: [250] imaginary construction only if we never forget what purposes it is designed to serve. We want first of all to analyze the tendency, prevailing in every action, toward the establishment of an evenly rotating economy; in doing so, we must always take into account that this tendency can never attain its goal in a universe not perfectly rigid and immutable, that is, in a universe which is living and not dead. Secondly, we need to comprehend in what respects the conditions of a living world in which there is action differ from those of a rigid world. This we can discover only by the argumentum a contrario [(Latin) argument or proof by contrast or the direct opposite] provided by the image of a rigid economy. Thus we are led to the insight that dealing with the uncertain conditions of the unknown future—that is, speculation—is inherent in every action, and that profit and loss are necessary features of acting which cannot be conjured away by any wishful thinking. The procedures adopted by those economists who are fully aware of these fundamental cognitions may be called the logical method of economics as contrasted with the technique of the mathematical method.

The mathematical economists disregard dealing with the actions which, under the imaginary and unrealizable assumption that no further new data will emerge, are supposed to bring about the evenly rotating economy. They do not notice the individual speculator who aims not at the establishment of the evenly rotating economy but at profiting from an action which adjusts the conduct of affairs better to the attainment of the ends sought by acting, the best possible removal of uneasiness. They stress exclusively the imaginary state of equilibrium which the whole complex of all such actions would attain in the absence of any further change in the data. They describe this imaginary equilibrium by sets of simultaneous differential equations. They fail to recognize that the state of affairs they are dealing with is a state in which there is no longer any action but only a succession of events provoked by a mystical prime mover. They devote all their efforts to describing, in mathematical symbols, various “equilibria,” that is, states of rest and the absence of action. They deal with equilibrium as if it were a real entity and not a limiting notion, a mere mental tool. What they are doing is vain playing with mathematical symbols, a pastime not suited to convey any knowledge.12

6: The Stationary Economy

The imaginary construction of a stationary economy has sometimes been confused with that of an evenly rotating economy. But in Edition: current; Page: [251] fact these two constructions differ.

The stationary economy is an economy in which the wealth and income of the individuals remain unchanged. With this image changes are compatible which would be incompatible with the construction of the evenly rotating economy. Population figures may rise or drop provided that they are accompanied by a corresponding rise or drop in the sum of wealth and income. The demand for some commodities may change; but these changes must occur so slowly that the transfer of capital from those branches of production which are to be restricted in accordance with them into those to be expanded can be effected by not replacing equipment used up in the shrinking branches and instead investing in the expanding ones.

The imaginary construction of a stationary economy leads to two further imaginary constructions: the progressing (expanding) economy and the retrogressing (shrinking) economy. In the former the per capita quota of wealth and income of the individuals and the population figure tend toward a higher numerical value, in the latter toward a lower numerical value.

In the stationary economy the total sum of all profits and of all losses is zero. In the progressing economy the total amount of profits exceeds the total amount of losses. In the retrogressing economy the total amount of profits is smaller than the total amount of losses.

The precariousness of these three imaginary constructions is to be seen in the fact that they imply the possibility of the measurement of wealth and income. As such measurements cannot be made and are not even conceivable, it is out of the question to apply them for a rigorous classification of the conditions of reality. Whenever economic history ventures to classify economic evolution within a certain period according to the scheme stationary, progressing or retrogressing, it resorts in fact to historical understanding and does not “measure.”

7: The Integration of Catallactic Functions

When men in dealing with the problems of their own actions, and when economic history, descriptive economics, and economic statistics in reporting other people’s actions, employ the terms entrepreneur, capitalist, landowner, worker, and consumer, they speak of ideal types. When economics employs the same terms it speaks of catallactic categories. The entrepreneurs, capitalists, landowners, workers, and consumers of economic theory are not living men as one meets them in the reality of life and history. They are the embodiment of distinct functions in the market operations. The fact that both acting Edition: current; Page: [252] men and historical sciences apply in their reasoning the results of economics and that they construct their ideal types on the basis of and with reference to the categories of praxeological theory, does not modify the radical logical distinction between ideal type and economic category. The economic categories we are concerned with refer to purely integrated functions, the ideal types refer to historical events. Living and acting man by necessity combines various functions. He is never merely a consumer. He is in addition either an entrepreneur, landowner, capitalist, or worker, or a person supported by the intake earned by such people. Moreover, the functions of the entrepreneur, the landowner, the capitalist, and the worker are very often combined in the same persons. History is intent upon classifying men according to the ends they aim at and the means they employ for the attainment of these ends. Economics, exploring the structure of acting in the market society without any regard to the ends people aim at and the means they employ, is intent upon discerning categories and functions. These are two different tasks. The difference can best be demonstrated in discussing the catallactic concept of the entrepreneur.

In the imaginary construction of the evenly rotating economy there is no room left for entrepreneurial activity, because this construction eliminates any change of data that could affect prices. As soon as one abandons this assumption of rigidity of data, one finds that action must needs be affected by every change in the data. As action necessarily is directed toward influencing a future state of affairs, even if sometimes only the immediate future of the next instant, it is affected by every incorrectly anticipated change in the data occurring in the period of time between its beginning and the end of the period for which it aimed to provide (period of provision13). Thus the outcome of action is always uncertain. Action is always speculation. This is valid not only with regard to a market economy but no less for Robinson Crusoe, the imaginary isolated actor, and for the conditions of a socialist economy. In the imaginary construction of an evenly rotating system nobody is an entrepreneur and speculator. In any real and living economy every actor is always an entrepreneur and speculator; the people taken care of by the actors—the minor family members in the market society and the masses of a socialist society—are, although themselves not actors and therefore not speculators, affected by the outcome of the actors’ speculations.

Economics, in speaking of entrepreneurs, has in view not men, but a definite function. This function is not the particular feature of a Edition: current; Page: [253] special group or class of men; it is inherent in every action and burdens every actor. In embodying this function in an imaginary figure, we resort to a methodological makeshift. The term entrepreneur as used by catallactic theory means: acting man exclusively seen from the aspect of the uncertainty inherent in every action. In using this term one must never forget that every action is embedded in the flux of time and therefore involves a speculation. The capitalists, the landowners, and the laborers are by necessity speculators. So is the consumer in providing for anticipated future needs. There’s many a slip ’twixt cup and lip.

Let us try to think the imaginary construction of a pure entrepreneur to its ultimate logical consequences. This entrepreneur does not own any capital. The capital required for his entrepreneurial activities is lent to him by the capitalists in the form of money loans. The law, it is true, considers him the proprietor of the various means of production purchased by expanding the sums borrowed. Nevertheless he remains propertyless as the amount of his assets is balanced by his liabilities. If he succeeds, the net profit is his. If he fails, the loss must fall upon the capitalists who have lent him the funds. Such an entrepreneur would, in fact, be an employee of the capitalists who speculates on their account and takes a 100 per cent share in the net profits without being concerned about the losses. But even if the entrepreneur is in a position to provide himself a part of the capital required and borrows only the rest, things are essentially not different. To the extent that the losses incurred cannot be borne out of the entrepreneur’s own funds, they fall upon the lending capitalists, whatever the terms of the contract may be. A capitalist is always also virtually an entrepreneur and speculator. He always runs the chance of losing his funds. There is no such thing as a perfectly safe investment.

The self-sufficient landowner who tills his estate only to supply his own household is affected by all changes influencing the fertility of his farm or his personal needs. Within a market economy the result of a farmer’s activities is affected by all changes regarding the importance of his piece of land for supplying the market. The farmer is clearly, even from the point of view of mundane terminology, an entrepreneur. No proprietor of any means of production, whether they are represented in tangible goods or in money, remains untouched by the uncertainty of the future. The employment of any tangible goods or money for production, i.e., the provision for later days, is in itself an entrepreneurial activity.

Things are essentially the same for the laborer. He is born the Edition: current; Page: [254] proprietor of certain abilities; his innate faculties are a means of production which is better fitted for some kinds of work, less fitted for others, and not at all fitted for still others.14 If he has acquired the skill needed for the performance of certain kinds of labor, he is, with regard to the time and the material outlays absorbed by this training in the position of an investor. He has made an input in the expectation of being compensated by an adequate output. The laborer is an entrepreneur in so far as his wages are determined by the price the market allows for the kind of work he can perform. This price varies according to the change in conditions in the same way in which the price of every other factor of production varies.

In the context of economic theory the meaning of the terms concerned is this: Entrepreneur means acting man in regard to the changes occurring in the data of the market. Capitalist and landowner mean acting man in regard to the changes in value and price which, even with all the market data remaining equal, are brought about by the mere passing of time as a consequence of the different valuation of present goods and of future goods. Worker means man in regard to the employment of the factor of production human labor. Thus every function is nicely integrated: the entrepreneur earns profit or suffers loss; the owners of means of production (capital goods or land) earn originary interest; the workers earn wages. In this sense we elaborate the imaginary construction of functional distribution as different from the actual historical distribution.15

Economics, however, always did and still does use the term “entrepreneur” in a sense other than that attached to it in the imaginary construction of functional distribution. It also calls entrepreneurs those who are especially eager to profit from adjusting production to the Edition: current; Page: [255] expected changes in conditions, those who have more initiative, more venturesomeness, and a quicker eye than the crowd, the pushing and promoting pioneers of economic improvement. This notion is narrower than the concept of an entrepreneur as used in the construction of functional distribution; it does not include many instances which the latter includes. It is awkward that the same term should be used to signify two different notions. It would have been more expedient to employ another term for this second notion—for instance, the term promoter.

It is to be admitted that the notion of the entrepreneur-promoter cannot be defined with praxeological rigor. (In this it is like the notion of money which also defies—different from the notion of a medium of exchange—a rigid praxeological definition.16) However, economics cannot do without the promoter concept. For it refers to a datum that is a general characteristic of human nature, that is present in all market transactions and marks them profoundly. This is the fact that various individuals do not react to a change in conditions with the same quickness and in the same way. The inequality of men, which is due to differences both in their inborn qualities and in the vicissitudes of their lives, manifests itself in this way too. There are in the market pacemakers and others who only imitate the procedures of their more agile fellow citizens. The phenomenon of leadership is no less real on the market than in any other branch of human activities. The driving force of the market, the element tending toward unceasing innovation and improvement, is provided by the restlessness of the promoter and his eagerness to make profits as large as possible.

There is, however, no danger that the equivocal use of this term may result in any ambiguity in the exposition of the catallactic system. Wherever any doubts are likely to appear, they can be dispelled by the employment of the term promoter instead of entrepreneur.

The Entrepreneurial Function in the Stationary Economy

The futures market can relieve a promoter of a part of his entrepreneurial function. As far as an entrepreneur has hedged himself through suitable forward transactions against losses he may possibly suffer, he ceases to be an entrepreneur and the entrepreneurial function devolves on the other party to the contract. The cotton spinner who, buying raw cotton for his mill, sells the same quantity forward has abandoned a part of his entrepreneurial function. He will neither profit nor lose from changes in the cotton price occurring in the period concerned. Of course, he does not entirely cease to serve in Edition: current; Page: [256] the entrepreneurial function. Those changes in the price of yarn in general or in the price of the special counts and kinds he produces which are not brought about by a change in the price of raw cotton affect him nonetheless. Even if he spins only as a contractor for a remuneration agreed upon, he is still in an entrepreneurial function with regard to the funds invested in his outfit.

We may construct the image of an economy in which the conditions required for the establishment of futures markets are realized for all kinds of goods and services. In such an imaginary construction the entrepreneurial function is fully separated from all other functions. There emerges a class of pure entrepreneurs. The prices determined on the futures markets direct the whole apparatus of production. The dealers in futures alone make profits and suffer losses. All other people are insured, as it were, against the possible adverse effects of the uncertainty of the future. They enjoy security in this regard. The heads of the various business units are virtually employees, as it were, with a fixed income.

If we further assume that this economy is a stationary economy and that all futures transactions are concentrated in one corporation, it is obvious that the total amount of this corporation’s losses precisely equals the total amount of its profits. We need only to nationalize this corporation in order to bring about a socialist state without profits and losses, a state of undisturbed security and stability. But this is so only because our definition of a stationary economy implies equality of the total sum of losses and that of profits. In a changing economy an excess either of profits or of losses must emerge.

It would be a waste of time to dwell longer upon such oversophisticated images which do not further the analysis of economic problems. The only reason for mentioning them is that they reflect ideas which are at the bottom of some criticisms made against the economic system of capitalism and of some delusive plans suggested for a socialist control of business. Now, it is true that a socialist scheme is logically compatible with the unrealizable imaginary constructions of an evenly rotating economy and of a stationary economy. The predilection with which mathematical economists almost exclusively deal with the conditions of these imaginary constructions and with the state of “equilibrium” implied in them, has made people oblivious of the fact that these are unreal, self-contradictory and imaginary expedients of thought and nothing else. They are certainly not suitable models for the construction of a living society of acting men.

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CHAPTER 15: The Market

1: The Characteristics of the Market Economy

The market economy is the social system of the division of labor under private ownership of the means of production. Everybody acts on his own behalf; but everybody’s actions aim at the satisfaction of other people’s needs as well as at the satisfaction of his own. Everybody in acting serves his fellow citizens. Everybody, on the other hand, is served by his fellow citizens. Everybody is both a means and an end in himself, an ultimate end for himself and a means to other people in their endeavors to attain their own ends.

This system is steered by the market. The market directs the individual’s activities into those channels in which he best serves the wants of his fellow men. There is in the operation of the market no compulsion and coercion. The state, the social apparatus of coercion and compulsion, does not interfere with the market and with the citizens’ activities directed by the market. It employs its power to beat people into submission solely for the prevention of actions destructive to the preservation and the smooth operation of the market economy. It protects the individual’s life, health, and property against violent or fraudulent aggression on the part of domestic gangsters and external foes. Thus the state creates and preserves the environment in which the market economy can safely operate. The Marxian slogan “anarchic production” pertinently characterizes this social structure as an economic system which is not directed by a dictator, a production tsar who assigns to each a task and compels him to obey this command. Each man is free; nobody is subject to a despot. Of his own accord the individual integrates himself into the cooperative system. The market directs him and reveals to him in what way he can best promote his own welfare as well as that of other people. The market is supreme. The market alone puts the whole social system in order and provides it with sense and meaning.

The market is not a place, a thing, or a collective entity. The market is a process, actuated by the interplay of the actions of the various individuals cooperating under the division of labor. The forces determining the—continually changing—state of the market are the Edition: current; Page: [258] value judgments of these individuals and their actions as directed by these value judgments. The state of the market at any instant is the price structure, i.e., the totality of the exchange ratios as established by the interaction of those eager to buy and those eager to sell. There is nothing inhuman or mystical with regard to the market. The market process is entirely a resultant of human actions. Every market phenomenon can be traced back to definite choices of the members of the market society.

The market process is the adjustment of the individual actions of the various members of the market society to the requirements of mutual cooperation. The market prices tell the producers what to produce, how to produce, and in what quantity. The market is the focal point to which the activities of the individuals converge. It is the center from which the activities of the individuals radiate.

The market economy must be strictly differentiated from the second thinkable—although not realizable—system of social cooperation under the division of labor: the system of social or governmental ownership of the means of production. This second system is commonly called socialism, communism, planned economy, or state capitalism. The market economy or capitalism, as it is usually called, and the socialist economy preclude one another. There is no mixture of the two systems possible or thinkable; there is no such thing as a mixed economy, a system that would be in part capitalistic and in part socialist. Production is directed by the market or by the decrees of a production tsar or a committee of production tsars.

If within a society based on private ownership by the means of production some of these means are publicly owned and operated—that is, owned and operated by the government or one of its agencies—this does not make for a mixed system which would combine socialism and capitalism. The fact that the state or municipalities own and operate some plants does not alter the characteristic features of the market economy. These publicly owned and operated enterprises are subject to the sovereignty of the market. They must fit themselves, as buyers of raw materials, equipment, and labor, and as sellers of goods and services, into the scheme of the market economy. They are subject to the laws of the market and thereby depend on the consumers who may or may not patronize them. They must strive for profits or, at least, to avoid losses. The government may cover losses of its plants or shops by drawing on public funds. But this neither eliminates nor mitigates the supremacy of the market; it merely shifts it to another sector. For the means for covering the losses must be raised by the imposition of taxes. But this taxation has Edition: current; Page: [259] its effects on the market and influences the economic structure according to the laws of the market. It is the operation of the market, and not the government collecting the taxes, that decides upon whom the incidence of the taxes falls and how they affect production and consumption. Thus the market, not a government bureau, determines the working of these publicly operated enterprises.

Nothing that is in any way connected with the operation of a market is in the praxeological or economic sense to be called socialism. The notion of socialism as conceived and defined by all socialists implies the absence of a market for factors of production and of prices of such factors. The “socialization” of individual plants, shops, and farms—that is, their transfer from private into public ownership—is a method of bringing about socialism by successive measures. It is a step on the way toward socialism, but not in itself socialism. (Marx and the orthodox Marxians flatly deny the possibility of such a gradual approach to socialism. According to their doctrine the evolution of capitalism will one day reach a point in which at one stroke capitalism is transformed into socialism.)

Government-operated enterprises and the Russian Soviet economy are, by the mere fact that they buy and sell on markets, connected with the capitalist system. They themselves bear witness to this connection by calculating in terms of money. They thus utilize the intellectual methods of the capitalist system that they fanatically condemn.

For monetary economic calculation is the intellectual basis of the market economy. The tasks set to acting within any system of the division of labor cannot be achieved without economic calculation. The market economy calculates in terms of money prices. That it is capable of such calculation was instrumental in its evolution and conditions its present-day operation. The market economy is real because it can calculate.

2: Capital Goods and Capital

There is an impulse inwrought in all living beings that directs them toward the assimilation of matter that preserves, renews, and strengthens their vital energy. The eminence of acting man is manifested in the fact that he consciously and purposefully aims at maintaining and enhancing his vitality. In the pursuit of this aim his ingenuity leads him to the construction of tools that first aid him in the appropriation of food, then, at a later stage, induce him to design methods of increasing the quantity of foodstuffs available, and, finally, enable him to provide for the satisfaction of the most urgently felt among those Edition: current; Page: [260] desires that are specifically human. As Böhm-Bawerk described it: Man chooses roundabout methods of production that require more time but compensate for this delay by generating more and better products.

At the outset of every step forward on the road to a more plentiful existence is saving—the provisionment of products that makes it possible to prolong the average period of time elapsing between the beginning of the production process and its turning out of a product ready for use and consumption. The products accumulated for this purpose are either intermediary stages in the technological process, i.e., tools and half-finished products, or goods ready for consumption that make it possible for man to substitute, without suffering want during the waiting period, a more time-absorbing process for another absorbing a shorter time. These goods are called capital goods. Thus, saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization. Without saving and capital accumulation there could not be any striving toward nonmaterial ends.1

From the notion of capital goods one must clearly distinguish the concept of capital.2 The concept of capital is the fundamental concept of economic calculation, the foremost mental tool of the conduct of affairs in the market economy. Its correlative is the concept of income.

The notions of capital and income as applied in accountancy and in the mundane reflections of which accountancy is merely a refinement, contrast the means and the ends. The calculating mind of the actor draws a boundary line between the consumer’s goods which he plans to employ for the immediate satisfaction of his wants and the goods of all orders—including those of the first order3—which he plans to employ for providing by further acting, for the satisfaction of future wants. The differentiation of means and ends thus becomes a differentiation of acquisition and consumption, of business and Edition: current; Page: [261] household, of trading funds and of household goods. The whole complex of goods destined for acquisition is evaluated in money terms, and this sum—the capital—is the starting point of economic calculation. The immediate end of acquisitive action is to increase or, at least, to preserve the capital. That amount which can be consumed within a definite period without lowering the capital is called income. If consumption exceeds the income available, the difference is called capital consumption. If the income available is greater than the amount consumed, the difference is called saving. Among the main tasks of economic calculation are those of establishing the magnitudes of income, saving, and capital consumption.

The reflection which led acting man to the notions implied in the concepts of capital and income are latent in every premeditation and planning of action. Even the most primitive husbandmen are dimly aware of the consequences of acts which to a modern accountant would appear as capital consumption. The hunter’s reluctance to kill a pregnant hind and the uneasiness felt even by the most ruthless warriors in cutting fruit trees were manifestations of a mentality which was influenced by such considerations. These considerations were present in the age-old legal institution of usufruct and in analogous customs and practices. But only people who are in a position to resort to monetary calculation can evolve to full clarity the distinction between an economic substance and the advantages derived from it, and can apply it neatly to all classes, kinds, and orders of goods and services. They alone can establish such distinctions with regard to the perpetually changing conditions of highly developed processing industries and the complicated structure of the social cooperation of hundreds of thousands of specialized jobs and performances.

Looking backward from the cognition provided by modern accountancy to the conditions of the savage ancestors of the human race, we may say metaphorically that they too used “capital.” A contemporary accountant could apply all the methods of his profession to their primitive tools of hunting and fishing, to their cattle breeding and their tilling of the soil, if he knew what prices to assign to the various items concerned. Some economists concluded therefrom that “capital” is a category of all human production, that it is present in every thinkable system of the conduct of production processes—i.e., no less in Robinson Crusoe’s involuntary hermitage than in a socialist society—and that it does not depend upon the practice of monetary calculation.4 This is, however, a confusion. Edition: current; Page: [262] The concept of capital cannot be separated from the context of monetary calculation and from the social structure of a market economy in which alone monetary calculation is possible. It is a concept which makes no sense outside the conditions of a market economy. It plays a role exclusively in the plans and records of individuals acting on their own account in such a system of private ownership of the means of production, and it developed with the spread of economic calculation in monetary terms.5

Modern accountancy is the fruit of a long historical evolution. Today there is, among businessmen and accountants, unanimity with regard to the meaning of capital. Capital is the sum of the money equivalent of all assets minus the sum of the money equivalent of all liabilities as dedicated at a definite date to the conduct of the operations of a definite business unit. It does not matter in what these assets may consist, whether they are pieces of land, buildings, equipment, tools, goods of any kind and order, claims, receivables, cash, or whatever.

It is a historical fact that in the early days of accountancy the tradesmen, the pacemakers on the way toward monetary calculation, did not for the most part include the money equivalent of their buildings and land in the notion of capital. It is another historical fact that agriculturists were slow in applying the capital concept to their land. Even today in the most advanced countries only a part of the farmers are familiar with the practice of sound accountancy. Many farmers acquiesce in a system of bookkeeping that neglects to pay heed to the land and its contribution to production. Their book entries do not include the money equivalent of the land and are consequently indifferent to changes in this equivalent. Such accounts are defective because they fail to convey that information which is the sole aim sought by capital accounting. They do not indicate whether or not the operation of the farm has brought about a deterioration in the land’s capacity to contribute to production, that is, in its objective use value. If an erosion of the soil has taken place, their books ignore it, and thus the calculated income (net yield) is greater than a more complete method of bookkeeping would have shown.

It is necessary to mention these historical facts because they influenced the endeavors of the economists to construct the notion of real capital.

The economists were and are still today confronted with the superstitious belief that the scarcity of factors of production could be brushed away, either entirely or at least to some extent, by increasing Edition: current; Page: [263] the amount of money in circulation and by credit expansion. In order to deal adequately with this fundamental problem of economic policy they considered it necessary to construct a notion of real capital and to oppose it to the notion of capital as applied by the businessman whose calculation refers to the whole complex of his acquisitive activities. At the time the economists embarked upon these endeavors the place of the money equivalent of land in the concept of capital was still questioned. Thus the economists thought it reasonable to disregard land in constructing their notion of real capital. They defined real capital as the totality of the produced factors of production available. Hairsplitting discussions were started as to whether inventories of consumers’ goods held by business units are or are not real capital. But there was almost unanimity that cash is not real capital.

Now this concept of a totality of the produced factors of production is an empty concept. The money equivalent of the various factors of production owned by a business unit can be determined and summed up. But if we abstract from such an evaluation in money terms, the totality of the produced factors of production is merely an enumeration of physical quantities of thousands and thousands of various goods. Such an inventory is of no use to acting. It is a description of a part of the universe in terms of technology and topography and has no reference whatever to the problems raised by the endeavors to improve human well-being. We may acquiesce in the terminological usage of calling the produced factors of production capital goods. But this does not render the concept of real capital any more meaningful.

The worst outgrowth of the use of the mythical notion of real capital was that economists began to speculate about a spurious problem called the productivity of (real) capital. A factor of production is by definition a thing that is able to contribute to the success of a process of production. Its market price reflects entirely the value that people attach to this contribution. The services expected from the employment of a factor of production (i.e., its contribution to productivity) are in market transactions paid according to the full value people attach to them. These factors are considered valuable only on account of these services. These services are the only reason why prices are paid for them. Once these prices are paid, nothing remains that can bring about further payments on the part of anybody as a compensation for additional productive services of these factors of production. It was a blunder to explain interest as an income derived from the productivity of capital.6

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No less detrimental was a second confusion derived from the real capital concept. People began to mediate upon a concept of social capital as different from private capital. Starting from the imaginary construction of a socialist economy, they were intent upon defining a capital concept suitable to the economic activities of the general manager of such a system. They were right in assuming that this manager would be eager to know whether his conduct of affairs was successful (viz., from the point of view of his own valuations and the ends aimed at in accordance with these valuations) and how much he could expend for his wards’ consumption without diminishing the available stock of factors of production and thus impairing the yield of further production. A socialist government would badly need the concepts of capital and income as a guide for its operations. However, in an economic system in which there is no private ownership of the means of production, no market, and no prices for such goods the concepts of capital and income are mere academic postulates devoid of any practical application. In a socialist economy there are capital goods, but no capital.

The notion of capital makes sense only in the market economy. It serves the deliberations and calculations of individuals or groups of individuals operating on their own account in such an economy. It is a device of capitalists, entrepreneurs, and farmers eager to make profits and to avoid losses. It is not a category of all acting. It is a category of acting within a market economy.

3: Capitalism

All civilizations have up to now been based on private ownership of the means of production. In the past civilization and private property have been linked together. Those who maintain that economics is an experimental science and nevertheless recommend public control of the means of production, lamentably contradict themselves. If historical experience could teach us anything, it would be that private property is inextricably linked with civilization. There is no experience to the effect that socialism could provide a standard of living as high as that provided by capitalism.7

The system of market economy has never been fully and purely tried. But there prevailed in the orbit of Western civilization since the Middle Ages by and large a general tendency toward the abolition of institutions hindering the operation of the market economy. With the successive progress of this tendency, population figures multiplied Edition: current; Page: [265] and the masses’ standard of living was raised to an unprecedented and hitherto undreamed of level. The average American worker enjoys amenities for which Croesus, Crassus, the Medici, and Louis XIV would have envied him.

The problems raised by the socialist and interventionist critique of the market economy are purely economic and can be dealt with only in the way in which this book tries to deal with them: by a thorough analysis of human action and all thinkable systems of social cooperation. The psychological problem of why people scorn and disparage capitalism and call everything they dislike “capitalistic” and everything they praise “socialistic” concerns history and must be left to the historians. But there are several other issues which we must stress at this point.

The advocates of totalitarianism consider “capitalism” a ghastly evil, an awful illness that came upon mankind. In the eyes of Marx it was an inevitable stage of mankind’s evolution, but for all that the worst of evils; fortunately salvation is imminent and will free man forever from this disaster. In the opinion of other people it would have been possible to avoid capitalism if only men had been more moral or more skillful in the choice of economic policies. All such lucubrations have one feature in common. They look upon capitalism as if it were an accidental phenomenon which could be eliminated without altering conditions that are essential in civilized man’s acting and thinking. As they neglect to bother about the problem of economic calculation, they are not aware of the consequences which the abolition of the monetary calculus is bound to bring about. They do not realize that socialist men, for whom arithmetic will be of no use in planning action, will differ entirely in their mentality and in their mode of thinking from our contemporaries. In dealing with socialism, we must not overlook this mental transformation, even if we were ready to pass over in silence the disastrous consequences which would result for man’s material well-being.

The market economy is a man-made mode of acting under the division of labor. But this does not imply that it is something accidental or artificial and could be replaced by another mode. The market economy is the product of a long evolutionary process. It is the outcome of man’s endeavors to adjust his action in the best possible way to the given conditions of his environment that he cannot alter. It is the strategy, as it were, by the application of which man has triumphantly progressed from savagery to civilization.

Some authors argue: Capitalism was the economic system which brought about the marvelous achievements of the last two hundred years; therefore it is done for because what was beneficial in the past Edition: current; Page: [266] cannot be so for our time and for the future. Such reasoning is in open contradiction to the principles of experimental cognition. There is no need at this point to raise again the question of whether or not the science of human action can adopt the methods of the experimental natural sciences. Even if it were permissible to answer this question in the affirmative, it would be absurd to argue as these à rebours [(French) the wrong way] experimentalists do. Experimental science argues that because a was valid in the past, it will be valid in the future too. It must never argue the other way around and assert that because a was valid in the past, it is not valid in the future.

It is customary to blame the economists for an alleged disregard of history. The economists, it is contended, consider the market economy as the ideal and eternal pattern of social cooperation. They concentrate their studies upon investigating the conditions of the market economy and neglect everything else. They do not bother about the fact that capitalism emerged only in the last two hundred years and that even today it is restricted to a comparatively small area of the earth’s surface and to a minority of peoples. There were and are, say these critics, other civilizations with a different mentality and different modes of conducting economic affairs. Capitalism is, when seen sub specie aeternitatis [(Latin) from the viewpoint or mental image of eternity], a passing phenomenon, an ephemeral stage of historical evolution, just the transition from precapitalistic ages to a post-capitalistic future.

All these criticisms are spurious. Economics is, of course, not a branch of history or of any other historical science. It is the theory of all human action, the general science of the immutable categories of action and of their operation under all thinkable special conditions under which man acts. It provides as such the indispensable mental tool for dealing with historical and ethnographic problems. A historian or an ethnographer who neglects in his work to take full advantage of the results of economics is doing a poor job. In fact he does not approach the subject matter of his research unaffected by what he disregards as theory. He is at every step of his gathering of allegedly unadulterated facts, in arranging these facts, and in his conclusions derived from them, guided by confused and garbled remnants of perfunctory economic doctrines constructed by botchers in the centuries preceding the elaboration of an economic science and long since entirely exploded.

The analysis of the problems of the market society, the only pattern of human action in which calculation can be applied in planning action, opens access to the analysis of all thinkable modes of action and of all economic problems with which historians and ethnographers are confronted. All noncapitalistic methods of economic Edition: current; Page: [267] management can be studied only under the hypothetical assumption that in them too cardinal numbers can be used in recording past action and planning future action. This is why economists place the study of the pure market economy in the center of their investigations.

It is not the economists who lack the “historical sense” and ignore the factor of evolution, but their critics. The economists have always been fully aware of the fact that the market economy is the product of a long historical process which began when the human race emerged from the ranks of the other primates. The champions of what is mistakenly called “historicism” are intent upon undoing the effects of evolutionary changes. In their eyes everything the existence of which they cannot trace back to a remote past or cannot discover in the customs of some primitive Polynesian tribes is artificial, even decadent. They consider the fact that an institution was unknown to savages as a proof of its uselessness and rottenness. Marx and Engels and the Prussian professors of the Historical School exulted when they learned that private property is “only” a historical phenomenon. For them this was the proof that their socialist plans were realizable.8

The creative genius is at variance with his fellow citizens. As the pioneer of things new and unheard of he is in conflict with their uncritical acceptance of traditional standards and values. In his eyes the routine of the regular citizen, the average or common man, is simply stupidity. For him “bourgeois” is a synonym of imbecility.9Edition: current; Page: [268] The frustrated artists who take delight in aping the genius’s mannerism in order to forget and to conceal their own impotence adopt this terminology. These Bohemians call everything they dislike “bourgeois.” Since Marx has made the term “capitalist” equivalent to “bourgeois,” they use both words synonymously. In the vocabularies of all languages the words “capitalistic” and “bourgeois” signify today all that is shameful, degrading, and infamous.10 Contrariwise, people call all that they deem good and praiseworthy “socialist.” The regular scheme of arguing is this: A man arbitrarily calls anything he dislikes “capitalistic,” and then deduces from this appellation that the thing is bad.

This semantic confusion goes still further. Sismondi, the romantic eulogists of the Middle Ages, all socialist authors, the Prussian Historical School, and the American Institutionalists taught that capitalism is an unfair system of exploitation sacrificing the vital interests of the majority of people for the sole benefit of a small group of profiteers. No decent man can advocate this “mad” system. The economists who contend that capitalism is beneficial not only to a small group but to everyone are “sycophants of the bourgeoisie.” They are either too dull to recognize the truth or bribed apologists of the selfish class interests of the exploiters.

Capitalism, in the terminology of these foes of liberty, democracy, and the market economy, means the economic policy advocated by big business and millionaires. Confronted with the fact that some—but certainly not all—wealthy entrepreneurs and capitalists nowadays favor measures restricting free trade and competition and resulting in monopoly, they say: Contemporary capitalism stands for protectionism, cartels, and the abolition of competition. It is true, they add, that at a definite period of the past British capitalism favored free trade both on the domestic market and in international relations. This was because at that time the class interests of the British bourgeoisie were best served by such a policy. Conditions, however, changed and today capitalism, i.e., the doctrine advocated by the exploiters, aims at another policy.

It has already been pointed out that this doctrine badly distorts both economic theory and historical facts.11 There were and there will always be people whose selfish ambitions demand protection for vested interests and who hope to derive advantage from measures restricting competition. Entrepreneurs grown old and tired and the decadent heirs of people who succeeded in the past dislike the agile Edition: current; Page: [269] parvenus who challenge their wealth and their eminent social position. Whether or not their desire to make economic conditions rigid and to hinder improvements can be realized, depends on the climate of public opinion. The ideological structure of the nineteenth century, as fashioned by the prestige of the teachings of the liberal economists, rendered such wishes vain. When the technological improvements of the age of liberalism revolutionized the traditional methods of production, transportation, and marketing, those whose vested interests were hurt did not ask for protection because it would have been a hopeless venture. But today it is deemed a legitimate task of government to prevent an efficient man from competing with the less efficient. Public opinion sympathizes with the demands of powerful pressure groups to stop progress. The butter producers are with considerable success fighting against margarine and the musicians against recorded music. The labor unions are deadly foes of every new machine. It is not amazing that in such an environment less efficient businessmen aim at protection against more efficient competitors.

It would be correct to describe this state of affairs in this way: Today many or some groups of business are no longer liberal; they do not advocate a pure market economy and free enterprise, but, on the contrary, are asking for various measures of government interference with business. But it is entirely misleading to say that the meaning of the concept of capitalism has changed and that “mature capitalism”—as the American Institutionalists call it—or “late capitalism”—as the Marxians call it—is characterized by restrictive policies to protect the vested interests of wage earners, farmers, shopkeepers, artisans, and sometimes also of capitalists and entrepreneurs. The concept of capitalism is as an economic concept immutable; if it means anything, it means the market economy. One deprives oneself of the semantic tools to deal adequately with the problems of contemporary history and economic policies if one acquiesces in a different terminology. This faulty nomenclature becomes understandable only if we realize that the pseudo-economists and the politicians who apply it want to prevent people from knowing what the market economy really is. They want to make people believe that all the repulsive manifestations of restrictive government policies are produced by “capitalism.”

4: The Sovereignty of the Consumers

The direction of all economic affairs is in the market society a task of the entrepreneurs. Theirs is the control of production. They are at the helm and steer the ship. A superficial observer would believe that they are supreme. But they are not. They are bound to obey unconditionally the captain’s orders. The captain is the consumer. Edition: current; Page: [270] Neither the entrepreneurs nor the farmers nor the capitalists determine what has to be produced. The consumers do that. If a businessman does not strictly obey the orders of the public as they are conveyed to him by the structure of market prices, he suffers losses, he goes bankrupt, and is thus removed from his eminent position at the helm. Other men who did better in satisfying the demand of the consumers replace him.

The consumers patronize those shops in which they can buy what they want at the cheapest price. Their buying and their abstention from buying decides who should own and run the plants and the farms. They make poor people rich and rich people poor. They determine precisely what should be produced, in what quality, and in what quantities. They are merciless bosses, full of whims and fancies, changeable and unpredictable. For them nothing counts other than their own satisfaction. They do not care a whit for past merit and vested interests. If something is offered to them that they like better or that is cheaper, they desert their old purveyors. In their capacity as buyers and consumers they are hard-hearted and callous, without consideration for other people.

Only the sellers of goods and services of the first order are in direct contact with the consumers and directly depend on their orders. But they transmit the orders received from the public to all those producing goods and services of the higher orders. For the manufacturers of consumers’ goods, the retailers, the service trades, and the professions are forced to acquire what they need for the conduct of their own business from those purveyors who offer them at the cheapest price. If they were not intent upon buying in the cheapest market and arranging their processing of the factors of production so as to fill the demands of the consumers in the best and cheapest way, they would be forced to go out of business. More efficient men who succeeded better in buying and processing the factors of production would supplant them. The consumer is in a position to give free rein to his caprices and fancies. The entrepreneurs, capitalists, and farmers have their hands tied; they are bound to comply in their operations with the orders of the buying public. Every deviation from the lines prescribed by the demand of the consumers debits their account. The slightest deviation, whether willfully brought about or caused by error, bad judgment, or inefficiency, restricts their profits or makes them disappear. A more serious deviation results in losses and thus impairs or entirely absorbs their wealth. Capitalists, entrepreneurs, and landowners can only preserve and increase their wealth by filling best the orders of the consumers. They are not free to spend money Edition: current; Page: [271] which the consumers are not prepared to refund to them in paying more for the products. In the conduct of their business affairs they must be unfeeling and stony-hearted because the consumers, their bosses, are themselves unfeeling and stony-hearted.

The consumers determine ultimately not only the prices of the consumers’ goods, but no less the prices of all factors of production. They determine the income of every member of the market economy. The consumers, not the entrepreneurs, pay ultimately the wages earned by every worker, the glamorous movie star as well as the charwoman. With every penny spent the consumers determine the direction of all production processes and the details of the organization of all business activities. This state of affairs has been described by calling the market a democracy in which every penny gives a right to cast a ballot.12 It would be more correct to say that a democratic constitution is a scheme to assign to the citizens in the conduct of government the same supremacy the market economy gives them in their capacity as consumers. However, the comparison is imperfect. In the political democracy only the votes cast for the majority candidate or the majority plan are effective in shaping the course of affairs. The votes polled by the minority do not directly influence policies. But on the market no vote is cast in vain. Every penny spent has the power to work upon the production processes. The publishers cater not only to the majority by publishing detective stories, but also to the minority reading lyrical poetry and philosophical tracts. The bakeries bake bread not only for healthy people, but also for the sick on special diets. The decision of a consumer is carried into effect with the full momentum he gives it through his readiness to spend a definite amount of money.

It is true, in the market the various consumers have not the same voting right. The rich cast more votes than the poorer citizens. But this inequality is itself the outcome of a previous voting process. To be rich, in a pure market economy, is the outcome of success in filling best the demands of the consumers. A wealthy man can preserve his wealth only by continuing to serve the consumers in the most efficient way.

Thus the owners of the material factors of production and the entrepreneurs are virtually mandataries or trustees of the consumers, revocably appointed by an election daily repeated.

There is in the operation of a market economy only one instance in which the proprietary class is not completely subject to the supremacy Edition: current; Page: [272] of the consumers. Monopoly prices are an infringement of the sway of the consumers.

The Metaphorical Employment of the Terminology of Political Rule

The orders given by businessmen in the conduct of their affairs can be heard and seen. Nobody can fail to become aware of them. Even messenger boys know that the boss runs things around the shop. But it requires a little more brains to notice the entrepreneur’s dependence on the market. The orders given by the consumers are not tangible, they cannot be perceived by the senses. Many people lack the discernment to take cognizance of them. They fall victim to the delusion that entrepreneurs and capitalists are irresponsible autocrats whom nobody calls to account for their actions.13

The outgrowth of this mentality is the practice of applying to business the terminology of political rule and military action. Successful businessmen are called kings or dukes, their enterprises an empire, a kingdom, or a dukedom. If this idiom were only a harmless metaphor, there would be no need to criticize it. But it is the source of serious errors which play a sinister role in contemporary doctrines.

Government is an apparatus of compulsion and coercion. It has the power to obtain obedience by force. The political sovereign, be it an autocrat or the people as represented by its mandataries, has power to crush rebellions as long as his ideological might subsists.

The position which entrepreneurs and capitalists occupy in the market economy is of a different character. A “chocolate king” has no power over the consumers, his patrons. He provides them with chocolate of the best possible quality and at the cheapest price. He does not rule the consumers, he serves them. The consumers are not tied to him. They are free to stop patronizing his shops. He loses his “kingdom” if the consumers prefer to spend their pennies elsewhere. Nor does he “rule” his workers. He hires their services by paying them precisely that amount which the consumers are ready to restore to him in buying the product. Still less do the capitalists and entrepreneurs exercise political control. The civilized nations of Europe and America were long controlled by governments which did not considerably hinder the operation of the market economy. Today these countries too are dominated by parties which are hostile to capitalism and believe that every harm inflicted upon capitalists and entrepreneurs is extremely beneficial to the people.

In an unhampered market economy the capitalists and entrepreneurs Edition: current; Page: [273] cannot expect an advantage from bribing officeholders and politicians. On the other hand, the officeholders and politicians are not in a position to blackmail businessmen and to extort graft from them. In an interventionist country powerful pressure groups are intent upon securing for their members privileges at the expense of weaker groups and individuals. Then the businessmen may deem it expedient to protect themselves against discriminatory acts on the part of the executive officers and the legislature by bribery; once used to such methods, they may try to employ them in order to secure privileges for themselves. At any rate the fact that businessmen bribe politicians and officeholders and are blackmailed by such people does not indicate that they are supreme and rule the countries. It is those ruled—and not the rulers—who bribe and are paying tribute.

The majority of businessmen are prevented from resorting to bribery either by their moral convictions or by fear. They venture to preserve the free enterprise system and to defend themselves against discrimination by legitimate democratic methods. They form trade associations and try to influence public opinion. The results of these endeavors have been rather poor, as is evidenced by the triumphant advance of anticapitalist policies. The best that they have been able to achieve is to delay for a while some especially obnoxious measures.

Demagogues misrepresent this state of affairs in the crassest way. They tell us that these associations of bankers and manufacturers are the true rulers of their countries and that the whole apparatus of what they call “plutodemocratic” government is dominated by them. A simple enumeration of the laws passed in the last decades by any country’s legislature is enough to explode such legends.

5: Competition

In nature there prevail irreconcilable conflicts of interests. The means of subsistence are scarce. Proliferation tends to outrun subsistence. Only the fittest plants and animals survive. The antagonism between an animal starving to death and another that snatches the food away from it is implacable.

Social cooperation under the division of labor removes such antagonisms. It substitutes partnership and mutuality for hostility. The members of society are united in a common venture.

The term competition as applied to the conditions of animal life signifies the rivalry between animals which manifests itself in their search for food. We may call this phenomenon biological competition. Biological competition must not be confused with social competition, i.e., the striving of individuals to attain the most favorable position in the system of social cooperation. As there will always be Edition: current; Page: [274] positions which men value more highly than others, people will strive for them and try to outdo rivals. Social competition is consequently present in every conceivable mode of social organization. If we want to think of a state of affairs in which there is no social competition, we must construct the image of a socialist system in which the chief in his endeavors to assign to everybody his place and task in society is not aided by any ambition on the part of his subjects. The individuals are entirely indifferent and do not apply for special appointments. They behave like the stud horses which do not try to put themselves in a favorable light when the owner picks out the stallion to impregnate his best brood mare. But such people would no longer be acting men.

Catallactic competition is emulation between people who want to surpass one another. It is not a fight, although it is usual to apply to it in a metaphorical sense the terminology of war and internecine conflict, of attack and defense, of strategy and tactics. Those who fail are not annihilated; they are removed to a place in the social system that is more modest, but more adequate to their achievements than that which they had planned to attain.

In a totalitarian system, social competition manifests itself in the endeavors of people to court the favor of those in power. In the market economy, competition manifests itself in the fact that the sellers must outdo one another by offering better or cheaper goods and services, and that the buyers must outdo one another by offering higher prices. In dealing with this variety of social competition which may be called catallactic competition, we must guard ourselves against various popular fallacies.

The classical economists favored the abolition of all trade barriers preventing people from competing on the market. Such restrictive laws, they explained, result in shifting production from those places in which natural conditions of production are more favorable to places in which they are less favorable. They protect the less efficient man against his more efficient rival. They tend to perpetuate backward technological methods of production. In short they curtail production and thus lower the standard of living. In order to make all people more prosperous, the economists argued, competition should be free to everybody. In this sense they used the term free competition. There was nothing metaphysical in their employment of the term free. They advocated the nullification of privileges barring people from access to certain trades and markets. All the sophisticated lucubrations caviling at the metaphysical connotations of the adjective free as applied to competition are spurious; they have no reference whatever to the catallactic problem of competition.

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As far as natural conditions come into play, competition can only be “free” with regard to those factors of production which are not scarce and therefore not objects of human action. In the catallactic field competition is always restricted by the inexorable scarcity of the economic goods and services. Even in the absence of institutional barriers erected to restrict the number of those competing, the state of affairs is never such as to enable everyone to compete in all sectors of the market. In each sector only comparatively small groups can engage in competition.

Catallactic competition, one of the characteristic features of the market economy, is a social phenomenon. It is not a right, guaranteed by the state and the laws, that would make it possible for every individual to choose ad libitum the place in the structure of the division of labor he likes best. To assign to everybody his proper place in society is the task of the consumers. Their buying and abstention from buying is instrumental in determining each individual’s social position. Their supremacy is not impaired by any privileges granted to the individuals qua producers. Entrance into a definite branch of industry is virtually free to newcomers only as far as the consumers approve of this branch’s expansion or as far as the newcomers succeed in supplanting those already occupied in it by filling better or more cheaply the demands of the consumers. Additional investment is reasonable only to the extent that it fills the most urgent among the not yet satisfied needs of the consumers. If the existing plants are sufficient, it would be wasteful to invest more capital in the same industry. The structure of market prices pushes the new investors into other branches.

It is necessary to emphasize this point because the failure to grasp it is at the root of many popular complaints about the impossibility of competition. Some sixty years ago people used to declare: You cannot compete with the railroad companies; it is impossible to challenge their position by starting competing lines; in the field of land transportation there is no longer competition. The truth was that at that time the already operating lines were by and large sufficient. For additional capital investment the prospects were more favorable in improving the serviceableness of the already operating lines and in other branches of business than in the construction of new railroads. However, this did not interfere with further technological progress in transportation technique. The bigness and the economic “power” of the railroad companies did not impede the emergence of the motor car and the airplane.

Today people assert the same with regard to various branches of big business: You cannot challenge their position, they are too big Edition: current; Page: [276] and too powerful. But competition does not mean that anybody can prosper by simply imitating what other people do. It means the opportunity to serve the consumers in a better or cheaper way without being restrained by privileges granted to those whose vested interests the innovation hurts. What a newcomer who wants to defy the vested interests of the old established firms needs most is brains and ideas. If his project is fit to fill the most urgent of the unsatisfied needs of the consumers or to purvey them at a cheaper price than their old purveyors, he will succeed in spite of the much talked of bigness and power of the old firms.

Catallactic competition must not be confused with prize fights and beauty contests. The purpose of such fights and contests is to discover who is the best boxer or the prettiest girl. The social function of catallactic competition is, to be sure, not to establish who is the smartest boy and to reward the winner by a title and medals. Its function is to safeguard the best satisfaction of the consumers attainable under the given state of the economic data.

Equality of opportunity is a factor neither in prize fights and beauty contests nor in any other field of competition, whether biological or social. The immense majority of people are by the physiological structure of their bodies deprived of a chance to attain the honors of a boxing champion or a beauty queen. Only very few people can compete on the labor market as opera singers and movie stars. The most favorable opportunity to compete in the field of scientific achievement is provided to the university professors. Yet, thousands and thousands of professors pass away without leaving any trace in the history of ideas and scientific progress, while many of the handicapped outsiders win glory through marvelous contributions.

It is usual to find fault with the fact that catallactic competition is not open to everybody in the same way. The start is much more difficult for a poor boy than for the son of a wealthy man. But the consumers are not concerned about the problem of whether or not the men who shall serve them start their careers under equal conditions. Their only interest is to secure the best possible satisfaction of their needs. As the system of hereditary property is more efficient in this regard, they prefer it to other less efficient systems. They look at the matter from the point of view of social expediency and social welfare, not from the point of view of an alleged, imaginary, and unrealizable “natural” right of every individual to compete with equal opportunity. The realization of such a right would require placing at a disadvantage those born with better intelligence and greater will power than the average man. It is obvious that this would be absurd.

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The term competition is mainly employed as the antithesis of monopoly. In this mode of speech the term monopoly is applied in different meanings which must be clearly separated.

The first connotation of monopoly, very frequently implied in the popular use of the term, signifies a state of affairs in which the monopolist, whether an individual or a group of individuals, exclusively controls one of the vital conditions of human survival. Such a monopolist has the power to starve to death all those who do not obey his orders. He dictates and the others have no alternative but either to surrender or to die. With regard to such a monopoly there is no market or any kind of catallactic competition. The monopolist is the master and the rest are slaves entirely dependent on his good graces. There is no need to dwell upon this kind of monopoly. It has no reference whatever to a market economy. It is enough to cite one instance. A world-embracing socialist state would exercise such an absolute and total monopoly; it would have the power to crush its opponents by starving them to death.14

The second connotation of monopoly differs from the first in that it describes a state of affairs compatible with the conditions of a market economy. A monopolist in this sense is an individual or a group of individuals, fully combining for joint action, who has the exclusive control of the supply of a definite commodity. If we define the term monopoly in this way, the domain of monopoly appears very vast. The products of the processing industries are more or less different from one another. Each factory turns out products different from those of the other plants. Each hotel has a monopoly on the sale of its services on the site of its premises. The professional services rendered by a physician or a lawyer are never perfectly equal to those rendered by any other physician or lawyer. Except for certain raw materials, foodstuffs, and other staple goods, monopoly is everywhere on the market.

However, the mere phenomenon of monopoly is without any significance and relevance for the operation of the market and the determination of prices. It does not give the monopolist any advantage in selling his products. Under copyright law every rhymester enjoys a monopoly in the sale of his poetry. But this does not influence the market. It may happen that no price whatever can be realized for his stuff and that his books can only be sold at their waste paper value.

Monopoly in this second connotation of the term becomes a factor in the determination of prices only if the demand curve for the Edition: current; Page: [278] monopoly good concerned is shaped in a particular way. If conditions are such that the monopolist can secure higher net proceeds by selling a smaller quantity of his product at a higher price than by selling a greater quantity of his supply at a lower price, there emerges a monopoly price higher than the potential market price would have been in the absence of monopoly. Monopoly prices are an important market phenomenon, while monopoly as such is only important if it can result in the formation of monopoly prices.

It is customary to call prices which are not monopoly prices competitive prices. While it is questionable whether or not this terminology is expedient, it is generally accepted and it would be difficult to change it. But one must guard oneself against its misinterpretation. It would be a serious blunder to deduce from the antithesis between monopoly price and competitive price that the monopoly price is the outgrowth of the absence of competition. There is always catallactic competition on the market. Catallactic competition is no less a factor in the determination of monopoly prices than it is in the determination of competitive prices. The shape of the demand curve that makes the appearance of monopoly prices possible and directs the monopolists’ conduct is determined by the competition of all other commodities competing for the buyers’ dollars. The higher the monopolist fixes the price at which he is ready to sell, the more potential buyers turn their dollars toward other vendible goods. On the market every commodity competes with all other commodities.

There are people who maintain that the catallactic theory of prices is of no use for the study of reality because there has never been “free” competition or because, at least today, there is no longer any such thing. All these doctrines are wrong.15 They misconstrue the phenomena and simply do not know what competition really is. It is a fact that the history of the last decades is a record of policies aiming at the restriction of competition. It is the manifest intention of these schemes to grant privileges to certain groups of producers by protecting them against the competition of more efficient competitors. In many instances these policies have brought about the conditions required for the emergence of monopoly prices. In many other instances this was not the case and the result was only a state of affairs preventing many capitalists, entrepreneurs, farmers, and workers from entering those branches of industry in which they would have rendered the most valuable services to their fellow citizens. Catallactic Edition: current; Page: [279] competition has been seriously restricted, but the market economy is still in operation although sabotaged by government and labor union interference. The system of catallactic competition is still functioning although the productivity of labor has been seriously reduced.

It is the ultimate end of these anticompetition policies to substitute for capitalism a socialist system of planning in which there is no catallactic competition at all. While shedding crocodile tears about the decline of competition, the planners want to abolish this “mad” competitive system. They have attained their goal in some countries. But in the rest of the world they have only restricted competition in some branches of business by increasing the number of people competing in other branches.

The forces aiming at a restriction of competition play a great role in our day. It is an important task of the history of our age to deal with them. Economic theory has no need to refer to them in particular. The fact that there are trade barriers, privileges, cartels, government monopolies and labor unions is merely a datum of economic history. It does not require special theorems for its interpretation.

6: Freedom

Philosophers and lawyers have bestowed much pain upon attempts to define the concept of freedom or liberty. It can hardly be maintained that these endeavors have been successful.

The concept of freedom makes sense only as far as it refers to interhuman relations. There were authors who told stories about an original—natural—freedom which man was supposed to have enjoyed in a fabulous state of nature that preceded the establishment of social relations. Yet such mentally and economically self-sufficient individuals or families, roaming about the country, were only free as long as they did not run into a stronger fellow’s way. In the pitiless biological competition the stronger was always right, and the weaker was left no choice except unconditional surrender. Primitive man was certainly not born free.

Only within the frame of a social system can a meaning be attached to the term freedom. As a praxeological term, freedom refers to the sphere within which an acting individual is in a position to choose between alternative modes of action. A man is free in so far as he is permitted to choose ends and the means to be used for the attainment of those ends. A man’s freedom is most rigidly restricted by the laws of nature as well as by the laws of praxeology. He cannot attain ends which are incompatible with one another. If he chooses to indulge in gratifications that produce definite effects upon the Edition: current; Page: [280] functioning of his body or his mind, he must put up with these consequences. It would be inexpedient to say that man is not free because he cannot enjoy the pleasures of indulgence in certain drugs without being affected by their inevitable results, commonly considered as highly undesirable. While this is admitted by and large by all reasonable people, there is no such unanimity with regard to the appreciation of the laws of praxeology.

Man cannot have both the advantages derived from peaceful cooperation under the principle of the division of labor within society and the licence of embarking upon conduct that is bound to disintegrate society. He must choose between the observance of certain rules that make life within society possible and the poverty and insecurity of the “dangerous life” in a state of perpetual warfare among independent individuals. This is no less rigid a law determining the outcome of all human action than are the laws of physics.

Yet there is a far-reaching difference between the sequels resulting from a disregard of the laws of nature and those resulting from a disregard of the laws of praxeology. Of course, both categories of law take care of themselves without requiring any enforcement on the part of man. But the effects of a choice made by an individual are different. A man who absorbs poison harms himself alone. But a man who chooses to resort to robbery upsets the whole social order. While he alone enjoys the short-term gains derived from his action, the disastrous long-term effects harm all the people. His deed is a crime because it has detrimental effects on his fellow men. If society were not to prevent such conduct, it would soon become general and put an end to social cooperation and all the boons the latter confers upon everybody.

In order to establish and to preserve social cooperation and civilization, measures are needed to prevent asocial individuals from committing acts that are bound to undo all that man has accomplished in his progress from the Neanderthal level. In order to preserve the state of affairs in which there is protection of the individual against the unlimited tyranny of stronger and smarter fellows, an institution is needed that curbs all antisocial elements. Peace—the absence of perpetual fighting by everyone against everyone—can be attained only by the establishment of a system in which the power to resort to violent action is monopolized by a social apparatus of compulsion and coercion and the application of this power in any individual case is regulated by a set of rules—the man-made laws as distinguished both from the laws of nature and those of praxeology. The essential implement of a social system is the operation of such an apparatus commonly called government.

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The concepts of freedom and bondage make sense only when referring to the way in which government operates. It would be highly inexpedient and misleading to say that a man is not free because, if he wants to stay alive, his power to choose between a drink of water and one of potassium cyanide is restricted by nature. It would be no less inconvenient to call a man unfree because the law imposes sanctions upon his desire to kill another man and because the police and the penal courts enforce them. As far as the government—the social apparatus of compulsion and oppression—confines the exercise of its violence and the threat of such violence to the suppression and prevention of antisocial action, there prevails what reasonably and meaningfully can be called liberty. What is restrained is merely conduct that is bound to disintegrate social cooperation and civilization, thus throwing all people back to conditions that existed at the time Homo sapiens emerged from the purely animal existence of its nonhuman ancestors. Such coercion does not substantially restrict man’s power to choose. Even if there were no government enforcing man-made laws, the individual could not have both the advantages derived from the existence of social cooperation on the one hand, and, on the other, the pleasures of freely indulging in the rapacious animal instincts of aggression.

In the market economy, the laissez-faire type of social organization, there is a sphere within which the individual is free to choose between various modes of acting without being restrained by the threat of being punished. If, however, the government does more than protect people against violent or fraudulent aggression on the part of antisocial individuals, it reduces the sphere of the individual’s freedom to act beyond the degree to which it is restricted by praxeological law. Thus we may define freedom as that state of affairs in which the individual’s discretion to choose is not constrained by governmental violence beyond the margin within which the praxeological law restricts it anyway.

This is what is meant if one defines freedom as the condition of an individual within the frame of the market economy. He is free in the sense that the laws and the government do not force him to renounce his autonomy and self-determination to a greater extent than the inevitable praxeological law does. What he foregoes is only the animal freedom of living without any regard to the existence of other specimens of his species. What the social apparatus of compulsion and coercion achieves is that individuals, whom malice, short-sightedness or mental inferiority prevent from realizing that by indulging in acts that are destroying society they are hurting themselves and all other human beings, are compelled to avoid such acts.

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From this point of view one has to deal with the often-raised problem of whether conscription and the levy of taxes mean a restriction of freedom. If the principles of the market economy were acknowledged by all people all over the world, there would not be any reason to wage war and the individual states could live in undisturbed peace.16 But as conditions are in our age, a free nation is continually threatened by the aggressive schemes of totalitarian autocracies. If it wants to preserve its freedom, it must be prepared to defend its independence. If the government of a free country forces every citizen to cooperate fully in its designs to repel the aggressors and every able-bodied man to join the armed forces, it does not impose upon the individual a duty that would step beyond the tasks the praxeological law dictates. In a world full of unswerving aggressors and enslavers, integral unconditional pacifism is tantamount to unconditional surrender to the most ruthless oppressors. He who wants to remain free, must fight unto death those who are intent upon depriving him of his freedom. As isolated attempts on the part of each individual to resist are doomed to failure, the only workable way is to organize resistance by the government. The essential task of government is defense of the social system not only against domestic gangsters but also against external foes. He who in our age opposes armaments and conscription is, perhaps unbeknown to himself, an abettor of those aiming at the enslavement of all.

The maintenance of a government apparatus of courts, police officers, prisons, and of armed forces requires considerable expenditure. To levy taxes for these purposes is fully compatible with the freedom the individual enjoys in a free market economy. To assert this does not, of course, amount to a justification of the confiscatory and discriminatory taxation methods practiced today by the self-styled progressive governments. There is need to stress this fact, because in our age of interventionism and the steady “progress” toward totalitarianism the governments employ the power to tax for the destruction of the market economy.

Every step a government takes beyond the fulfillment of its essential functions of protecting the smooth operation of the market economy against aggression, whether on the part of domestic or foreign disturbers, is a step forward on a road that directly leads into the totalitarian system where there is no freedom at all.

Liberty and freedom are the conditions of man within a contractual society. Social cooperation under a system of private ownership of the factors of production means that within the range of the market Edition: current; Page: [283] the individual is not bound to obey and to serve an overload. As far as he gives and serves other people, he does so of his own accord in order to be rewarded and served by the receivers. He exchanges goods and services, he does not do compulsory labor and does not pay tribute. He is certainly not independent. He depends on the other members of society. But this dependence is mutual. The buyer depends on the seller and the seller on the buyer.

The main concern of many writers of the nineteenth and twentieth centuries was to misrepresent and to distort this obvious state of affairs. The workers, they said, are at the mercy of their employers. Now, it is true that the employer has the right to fire the employee. But if he makes use of this right in order to indulge in his whims, he hurts his own interests. It is to his own disadvantage if he discharges a better man in order to hire a less efficient one. The market does not directly prevent anybody from arbitrarily inflicting harm on his fellow citizens; it only puts a penalty upon such conduct. The shopkeeper is free to be rude to his customers provided he is ready to bear the consequences. The consumers are free to boycott a purveyor provided they are ready to pay the costs. What impels every man to the utmost exertion in the service of his fellow men and curbs innate tendencies toward arbitrariness and malice is, in the market, not compulsion and coercion on the part of gendarmes, hangmen, and penal courts; it is self-interest. The member of a contractual society is free because he serves others only in serving himself. What restrains him is only the inevitable natural phenomenon of scarcity. For the rest he is free in the range of the market.

There is no kind of freedom and liberty other than the kind which the market economy brings about. In a totalitarian hegemonic society the only freedom that is left to the individual, because it cannot be denied to him, is the freedom to commit suicide.

The state, the social apparatus of coercion and compulsion, is by necessity a hegemonic bond. If government were in a position to expand its power ad libitum, it could abolish the market economy and substitute for it all-around totalitarian socialism. In order to prevent this, it is necessary to curb the power of government. This is the task of all constitutions, bills of rights, and laws. This is the meaning of all struggles which men have fought for liberty.

The detractors of liberty are in this sense right in calling it a “bourgeois” issue and in blaming the rights guaranteeing liberty for being negative. In the realm of state and government, liberty means restraint imposed upon the exercise of the police power.

There would be no need to dwell upon this obvious fact if the Edition: current; Page: [284] champions of the abolition of liberty had not purposely brought about a semantic confusion. They realized that it was hopeless for them to fight openly and sincerely for restraint and servitude. The notions liberty and freedom had such prestige that no propaganda could shake their popularity. Since time immemorial in the realm of Western civilization liberty has been considered as the most precious good. What gave to the West its eminence was precisely its concern about liberty, a social ideal foreign to the oriental peoples. The social philosophy of the Occident is essentially a philosophy of freedom. The main content of the history of Europe and the communities founded by European emigrants and their descendants in other parts of the world was the struggle for liberty. “Rugged” individualism is the signature of our civilization. No open attack upon the freedom of the individual had any prospect of success.

Thus the advocates of totalitarianism chose other tactics. They reversed the meaning of words. They call true or genuine liberty the condition of the individuals under a system in which they have no right other than to obey orders. In the United States, they call themselves true liberals because they strive after such a social order. They call democracy the Russian methods of dictatorial government. They call the labor union methods of violence and coercion “industrial democracy.” They call freedom of the press a state of affairs in which only the government is free to publish books and newspapers. They define liberty as the opportunity to do the “right” things, and, of course, they arrogate to themselves the determination of what is right and what is not. In their eyes government omnipotence means full liberty. To free the police power from all restraints is the true meaning of their struggle for freedom.

The market economy, say these self-styled liberals, grants liberty only to a parasitic class of exploiters, the bourgeoisie. These scoundrels enjoy the freedom to enslave the masses. The wage earner is not free; he must toil for the sole benefit of his masters, the employers. The capitalists appropriate to themselves what according to the inalienable rights of man should belong to the worker. Under socialism the worker will enjoy freedom and human dignity because he will no longer have to slave for a capitalist. Socialism means the emancipation of the common man, means freedom for all. It means, moreover, riches for all.

These doctrines have been able to triumph because they did not encounter effective rational criticism. Some economists did a brilliant job in unmasking their crass fallacies and contradictions. But the public ignores the teachings of economics. The arguments advanced Edition: current; Page: [285] by average politicians and writers against socialism are either silly or irrelevant. It is useless to stand upon an alleged “natural” right of individuals to own property if other people assert that the foremost “natural” right is that of income equality. Such disputes can never be settled. It is beside the point to criticize nonessential, attendant features of the socialist program. One does not refute socialism by attacking the socialists’ stand on religion, marriage, birth control, and art. Moreover, in dealing with such matters the critics of socialism were often in the wrong.

In spite of these serious shortcomings of the defenders of economic freedom it was impossible to fool all the people all the time about the essential features of socialism. The most fanatical planners were forced to admit that their projects involve the abolition of many freedoms people enjoy under capitalism and “plutodemocracy.” Pressed hard, they resorted to a new subterfuge. The freedom to be abolished, they emphasize, is merely the spurious “economic” freedom of the capitalists that harms the common man. Outside the “economic sphere” freedom will not only be fully preserved, but considerably expanded. “Planning for Freedom” has lately become the most popular slogan of the champions of totalitarian government and the Russification of all nations.

The fallacy of this argument stems from the spurious distinction between two realms of human life and action, entirely separated from one another, viz., the “economic” sphere and the “noneconomic” sphere. With regard to this issue there is no need to add anything to what has been said in the preceding parts of this book. However, there is another point to be stressed.

Freedom, as people enjoyed it in the democratic countries of Western civilization in the years of the old liberalism’s triumph, was not a product of constitutions, bills of rights, laws, and statutes. Those documents aimed only at safeguarding liberty and freedom, firmly established by the operation of the market economy, against encroachments on the part of officeholders. No government and no civil law can guarantee and bring about freedom otherwise than by supporting and defending the fundamental institutions of the market economy. Government means always coercion and compulsion and is by necessity the opposite of liberty. Government is a guarantor of liberty and is compatible with liberty only if its range is adequately restricted to the preservation of what is called economic freedom. Where there is no market economy, the best-intentioned provisions of constitutions and laws remain a dead letter.

The freedom of man under capitalism is an effect of competition. Edition: current; Page: [286] The worker does not depend on the good graces of an employer. If his employer discharges him, he finds another employer.17 The consumer is not at the mercy of the shopkeeper. He is free to patronize another shop if he likes. Nobody must kiss other people’s hands or fear their disfavor. Interpersonal relations are businesslike. The exchange of goods and services is mutual; it is not a favor to sell or to buy, it is a transaction dictated by selfishness on both sides.

It is true that in his capacity as a producer every man depends either directly—e.g., the entrepreneur—or indirectly—e.g., the hired worker—on the demands of the consumers. However, this dependence upon the supremacy of the consumers is not unlimited. If a man has a weighty reason for defying the sovereignty of the consumers, he can try it. There is in the range of the market a very substantial and effective right to resist oppression. Nobody is forced to go into the liquor industry or into a gun factory if his conscience objects. He may have to pay a price for his conviction; there are in this world no ends the attainment of which is gratuitous. But it is left to a man’s own decision to choose between a material advantage and the call of what he believes to be his duty. In the market economy the individual alone is the supreme arbiter in matters of his satisfaction.18

Capitalist society has no means of compelling a man to change his occupation or his place of work other than to reward those complying with the wants of the consumers by higher pay. It is precisely this kind of pressure which many people consider as unbearable and hope to see abolished under socialism. They are too dull to realize that the only alternative is to convey to the authorities full power to determine in what branch and at what place a man should work.

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In his capacity as consumer man is no less free. He alone decides what is more and what is less important for him. He chooses how to spend his money according to his own will.

The substitution of economic planning for the market economy removes all freedom and leaves to the individual merely the right to obey. The authority directing all economic matters controls all aspects of a man’s life and activities. It is the only employer. All labor becomes compulsory labor because the employee must accept what the chief deigns to offer him. The economic tsar determines what and how much of each the consumer may consume. There is no sector of human life in which a decision is left to the individual’s value judgments. The authority assigns a definite task to him, trains him for his job, and employs him at the place and in the manner it deems expedient.

As soon as the economic freedom which the market economy grants to its members is removed, all political liberties and bills of rights become humbug. Habeas corpus and trial by jury are a sham if, under the pretext of economic expediency, the authority has full power to relegate every citizen it dislikes to the arctic or to a desert and to assign him “hard labor” for life. Freedom of the press is a mere blind if the authority controls all printing offices and paper plants. And so are all the other rights of men.

A man is free as far as he shapes his life according to his own plans. A man whose fate is determined by the plans of a superior authority, in which the exclusive power to plan is vested, is not free in the sense in which this term “free” was used and understood by all people until the semantic revolution of our day brought about a confusion of tongues.

7: Inequality of Wealth and Income

The inequality of individuals with regard to wealth and income is an essential feature of the market economy.

The fact that freedom is incompatible with equality of wealth and income has been stressed by many authors. There is no need to enter into an examination of the emotional arguments advanced in these writings. Neither is it necessary to raise the question of whether the renunciation of liberty could in itself guarantee the establishment of equality of wealth and income and whether or not a society could subsist on the basis of such an equality. Our task is merely to describe the role inequality plays in the framework of the market society.

In the market society direct compulsion and coercion are practiced only for the sake of preventing acts detrimental to social cooperation. Edition: current; Page: [288] For the rest individuals are not molested by the police power. The law-abiding citizen is free from the interference of jailers and hangmen. What pressure is needed to impel an individual to contribute his share to the cooperative effort of production is exercised by the price structure of the market. This pressure is indirect. It puts on each individual’s contribution a premium graduated according to the value which the consumers attach to this contribution. In rewarding the individual’s effort according to its value, it leaves to everybody the choice between a more or less complete utilization of his own faculties and abilities. This method cannot, of course, eliminate the disadvantages of inherent personal inferiority. But it provides an incentive to everybody to exert his faculties and abilities to the utmost.

The only alternative to this financial pressure as exercised by the market is direct pressure and compulsion as exercised by the police power. The authorities must be entrusted with the task of determining the quantity and quality of work that each individual is bound to perform. As individuals are unequal with regard to their abilities, this requires an examination of their personalities on the part of the authorities. The individual becomes an inmate of a penitentiary, as it were, to whom a definite task is assigned. If he fails to achieve what the authorities have ordered him to do, he is liable to punishment.

It is important to realize in what the difference consists between direct pressure exercised for the prevention of crime and that exercised for the extortion of a definite performance. In the former case all that is required from the individual is to avoid a certain mode of conduct, precisely determined by law. As a rule it is easy to establish whether or not this interdiction has been observed. In the second case the individual is liable to accomplish a definite task; the law forces him toward an indefinite action, the determination of which is left to the decision of the executive power. The individual is bound to obey whatever the administration orders him to do. Whether or not the command issued by the executive power was adequate to his forces and faculties and whether or not he has complied with it to the best of his abilities is extremely difficult to establish. Every citizen is with regard to all aspects of his personality and with regard to all manifestations of his conduct subject to the decisions of the authorities. In the market economy in a trial before a penal court the prosecutor is obliged to produce sufficient evidence that the defendant is guilty. But in matters of the performance of compulsory work it devolves upon the defendant to prove that the task assigned to him was beyond his abilities or that he has done all that can be expected of him. The administrators combine in their persons the offices of the Edition: current; Page: [289] legislator, the executor of the law, the public prosecutor, and the judge. The defendants are entirely at their mercy. This is what people have in mind when speaking of lack of freedom.

No system of the social division of labor can do without a method that makes individuals responsible for their contributions to the joint productive effort. If this responsibility is not brought about by the price structure of the market and the inequality of wealth and income it begets, it must be enforced by the methods of direct compulsion as practiced by the police.

8: Entrepreneurial Profit and Loss

Profit, in a broader sense, is the gain derived from action; it is the increase in satisfaction (decrease in uneasiness) brought about; it is the difference between the higher value attached to the result attained and the lower value attached to the sacrifices made for its attainment; it is, in other words, yield minus costs. To make profit is invariably the aim sought by any action. If an action fails to attain the ends sought, yield either does not exceed costs or lags behind costs. In the latter case the outcome means a loss, a decrease in satisfaction.

Profit and loss in this original sense are psychic phenomena and as such not open to measurement and a mode of expression which could convey to other people precise information concerning their intensity. A man can tell a fellow man that a suits him better than b; but he cannot communicate to another man, except in vague and indistinct terms, how much the satisfaction derived from a exceeds that derived from b.

In the market economy all those things that are bought and sold against money are marked with money prices. In the monetary calculus profit appears as a surplus of money received over money expended and loss as a surplus of money expended over money received. Profit and loss can be expressed in definite amounts of money. It is possible to ascertain in terms of money how much an individual has profited or lost. However, this is not a statement about this individual’s psychic profit or loss. It is a statement about a social phenomenon, about the individual’s contribution to the societal effort as it is appraised by the other members of society. It does not tell us anything about the individual’s increase or decrease in satisfaction or happiness. It merely reflects his fellow men’s evaluation of his contribution to social cooperation. This evaluation is ultimately determined by the efforts of every member of society to attain the highest possible psychic profit. It is the resultant of the composite effect of all these people’s subjective Edition: current; Page: [290] and personal value judgments as manifested in their conduct on the market. But it must not be confused with these value judgments as such.

We cannot even think of a state of affairs in which people act without the intention of attaining psychic profit and in which their actions result neither in psychic profit nor in psychic loss.19 In the imaginary construction of an evenly rotating economy there are neither money profits nor money losses. But every individual derives a psychic profit from his actions, or else he would not act at all. The farmer feeds and milks his cows and sells the milk because he values the things he can buy against the money thus earned more highly than the costs expended. The absence of money profits or losses in such an evenly rotating system is due to the fact that, if we disregard the differences brought about by the higher valuation of present goods as compared with future goods, the sum of the prices of all complementary factors needed for production precisely equals the price of the product.

In the changing world of reality differences between the sum of the prices of the complementary factors of production and the prices of the products emerge again and again. It is these differences that bring about money profits and money losses. As far as such changes affect the sellers of labor and those of the original nature-given factors of production and of the capitalists as moneylenders, we will deal with them later. At this point we are dealing with the promoters’ entrepreneurial profit and loss. It is this problem that people have in mind when employing the terms profit and loss in mundane speech.

Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur’s profits stem is his ability to anticipate better than other people the future demand of the consumers. If everybody is correct in anticipating the future state of the market of a certain commodity, its price and the prices of the complementary factors of production concerned would already today be adjusted to this future state. Neither profit nor loss can emerge for those embarking upon this line of business.

The specific entrepreneurial function consists in determining the Edition: current; Page: [291] employment of the factors of production. The entrepreneur is the man who dedicates them to special purposes. In doing so he is driven solely by the selfish interest in making profits and in acquiring wealth. But he cannot evade the law of the market. He can succeed only by best serving the consumers. His profit depends on the approval of his conduct by the consumers.

One must not confuse entrepreneurial profit and loss with other factors affecting the entrepreneur’s proceeds.

The entrepreneur’s technological ability does not affect the specific entrepreneurial profit or loss. As far as his own technological activities contribute to the returns earned and increase his net income, we are confronted with a compensation for work rendered. It is wages paid to the entrepreneur for his labor. Neither does the fact that not every process of production succeeds technologically in bringing about the product expected influence the specific entrepreneurial profit or loss. Such failures are either avoidable or unavoidable. In the first case they are due to the technologically inefficient conduct of affairs. Then the losses resulting are to be debited to the entrepreneur’s personal insufficiency, i.e., either to his lack of technological ability or to his lack of the ability to hire adequate helpers. In the second case the failures are due to the fact that the present state of technological knowledge prevents us from fully controlling the conditions on which success depends. This deficiency may be caused either by incomplete knowledge concerning the conditions of success or by ignorance of methods for controlling fully some of the known conditions. The price of the factors of production takes into account this unsatisfactory state of our knowledge and technological power. The price of arable land, for instance, takes into full account the fact that there are bad harvests, as it is determined by the anticipated average yield. The fact that the bursting of bottles reduces the output of champagne does not affect entrepreneurial profit and loss. It is merely one of the factors determining the cost of production and the price of champagne.20

Accidents affecting the process of production, the means of production, or the products while they are still in the hands of the entrepreneur are an item in the bill of production costs. Experience, which conveys to the businessman all other technological knowledge, provides Edition: current; Page: [292] him also with information about the average reduction in the quantity of physical output which such accidents are likely to bring about. By opening contingency reserves, he converts their effects into regular costs of production. With regard to contingencies the expected incidence of which is too rare and too irregular to be dealt with in this way by individual firms of normal size, concerted action on the part of sufficiently large groups of firms takes care of the matter. The individual firms cooperate under the principle of insurance against damage caused by fire, flood, or other similar contingencies. Then an insurance premium is substituted for an appropriation to a contingency reserve. At any rate, the risks incurred by accidents do not introduce uncertainty into the conduct of the technological processes.21 If an entrepreneur neglects to deal with them duly, he gives proof of his technical insufficiency. The losses thus incurred are to be debited to bad techniques applied, not to his entrepreneurial function.

The elimination of those entrepreneurs who fail to give to their enterprises the adequate degree of technological efficiency or whose technological ignorance vitiates their cost calculation is effected on the market in the same way in which those deficient in the performance of the specific entrepreneurial functions are eliminated. It may happen that an entrepreneur is so successful in his specific entrepreneurial function that he can compensate losses caused by his technological failure. It may also happen that an entrepreneur can counterbalance losses due to failure in his entrepreneurial function by the advantages derived from his technological superiority or from the differential rent yielded by the higher productivity of the factors of production he employs. But one must not confuse the various functions which are combined in the conduct of a business unit. The technologically more efficient entrepreneur earns higher wage rates or quasi-wage rates than the less efficient in the same way in which the more efficient worker earns more than the less efficient. The more efficient machine and the more fertile soil produce higher physical returns per unit of costs expended; they yield a differential rent when compared with the less efficient machine and the less fertile soil. The higher wage rates and the higher rent are, ceteris paribus, the corollary of higher physical output. But the specific entrepreneurial profits and losses are not produced by the quantity of physical output. They depend on the adjustment of output to the most urgent wants of the consumers. What produces them is the extent to which Edition: current; Page: [293] the entrepreneur has succeeded or failed in anticipating the future—necessarily uncertain—state of the market.

The entrepreneur is also jeopardized by political dangers. Government policies, revolutions, and wars can damage or annihilate his enterprise. Such events do not affect him alone; they affect the market economy as such and all individuals, although not all of them to the same extent. For the individual entrepreneur they are data which he cannot alter. If he is efficient, he will anticipate them in time. But it is not always possible for him to adjust his operations in such a way as to avoid damage. If the dangers expected concern only a part of the territory which is accessible to his entrepreneurial activities, he can avoid operating in the menaced areas and can prefer countries in which the danger is less imminent. But if he cannot emigrate, he must stay where he is. If all entrepreneurs were fully convinced that the total victory of Bolshevism was impending, they would nevertheless not abandon their entrepreneurial activities. The expectation of imminent expropriation will impel the capitalists to consume their funds. The entrepreneurs will be forced to adjust their plans to the market situation created by such capital consumption and the threatened nationalization of their shops and plants. But they will not stop operating. If some entrepreneurs go out of business, others will take their place—newcomers or old entrepreneurs expanding the size of their enterprises. In the market economy there will always be entrepreneurs. Policies hostile to capitalism may deprive the consumers of the greater part of the benefits they would have reaped from unhampered entrepreneurial activities. But they cannot eliminate the entrepreneurs as such if they do not entirely destroy the market economy.

The ultimate source from which entrepreneurial profit and loss are derived is the uncertainty of the future constellation of demand and supply.

If all entrepreneurs were to anticipate correctly the future state of the market, there would be neither profits nor losses. The prices of all the factors of production would already today be fully adjusted to tomorrow’s prices of the products. In buying the factors of production the entrepreneur would have to expend (with due allowance for the difference between the prices of present goods and future goods) no less an amount than the buyers will pay him later for the product. An entrepreneur can make a profit only if he anticipates future conditions more correctly than other entrepreneurs. Then he buys the complementary factors of production at prices the sum of Edition: current; Page: [294] which, including allowance for the time difference, is smaller than the price at which he sells the product.

If we want to construct the image of changing economic conditions in which there are neither profits nor losses, we must resort to an unrealizable assumption: perfect foresight of all future events on the part of all individuals. If those primitive hunters and fishermen to whom it is customary to ascribe the first accumulation of produced factors of production had known in advance all the future vicissitudes of human affairs, and if they and all their descendants until the last day of judgment, equipped with the same omniscience, had appraised all factors of production accordingly, entrepreneurial profits and losses would never have emerged. Entrepreneurial profits and losses are created through the discrepancy between the expected prices and the prices later really fixed on the markets. It is possible to confiscate profits and to transfer them from the individuals to whom they have accrued to other people. But neither profits nor losses can ever disappear from a changing world not populated solely with omniscient people.

9: Entrepreneurial Profits and Losses in a Progressing Economy

In the imaginary construction of a stationary economy the total sum of all entrepreneurs’ profits equals the total sum of all entrepreneurs’ losses. What one entrepreneur profits is in the total economic system counterbalanced by another entrepreneur’s loss. The surplus which all the consumers together expend for the acquisition of a certain commodity is counterbalanced by the reduction in their expenditure for the acquisition of other commodities.22

It is different in a progressing economy.

We call a progressing economy an economy in which the per capita quota of capital invested is increasing. In using this term we do not imply value judgments. We adopt neither the “materialistic” view that such a progression is good nor the “idealistic” view that it is bad or at least irrelevant from a “higher point of view.” Of course, it is a well-known fact that the immense majority of people consider the consequences of progress in this sense as the most desirable state of affairs and yearn for conditions which can be realized only in a progressing economy.

In the stationary economy the entrepreneurs, in the pursuit of their Edition: current; Page: [295] specific functions, cannot achieve anything other than to withdraw factors of production, provided that they are still convertible,23 from one line of business in order to employ them in another line, or to direct the restoration of the equivalent of capital goods used up in the course of production processes toward the expansion of certain branches of industry at the expense of other branches. In the progressing economy the range of entrepreneurial activities includes, moreover, the determination of the employment of the additional capital goods accumulated by new savings. The injection of these additional capital goods is bound to increase the total sum of the income produced, i.e., of that supply of consumers’ goods which can be consumed without diminishing the capital available and thereby without reducing the output of future production. The increase of income is effected either by an expansion of production without altering the technological methods of production or by an improvement in technological methods which would not have been feasible under the previous conditions of a less ample supply of capital goods.

It is out of this additional wealth that the surplus of the total sum of entrepreneurial profits over the total sum of entrepreneurial losses flows. But it can be easily demonstrated that this surplus can never exhaust the total increase in wealth brought about by economic progress. The laws of the market divide this additional wealth between the entrepreneurs and the suppliers of labor and those of certain material factors of production in such a way that the lion’s share goes to the nonentrepreneurial groups.

First of all we must realize that entrepreneurial profits are not a lasting phenomenon but only temporary. There prevails an inherent tendency for profits and losses to disappear. The market is always moving toward the emergence of the final prices and the final state of rest. If new changes in the data were not to interrupt this movement and not to create the need for a new adjustment of production to the altered conditions, the prices of all complementary factors of production would—due allowance being made for time preference—finally equal the price of the product, and nothing would be left for profits or losses. In the long run every increase of productivity benefits exclusively the workers and some groups of the owners of land and of capital goods.

In the groups of the owners of capital goods there are benefited:

1. Those whose saving has increased the quantity of capital goods Edition: current; Page: [296] available. They own this additional wealth, the outcome of their restraint in consuming.

2. The owners of those capital goods already previously existing which, thanks to the improvement in technological methods of production, are now better utilized than before. Such gains are, of course, temporary only. They are bound to disappear as they cause a tendency toward an intensified production of the capital goods concerned.

On the other hand, the increase in the quantity of capital goods available lowers the marginal productivity of these capital goods; it thus brings about a fall in the prices of the capital goods and thereby hurts the interests of all those capitalists who did not share at all or not sufficiently in the process of saving and the accumulation of the additional supply of capital goods.

In the group of the landowners all those are benefited for whom the new state of affairs results in a higher productivity of their farms, forests, fisheries, mines, and so on. On the other hand, all those are hurt whose property may become submarginal on account of the higher return yielded by the land owned by those benefited.

In the group of labor all derive a lasting gain from the increase in the marginal productivity of labor. But, on the other hand, in the short run some may suffer disadvantages. These are people who were specialized in the performance of work which becomes obsolete as a result of technological improvement and are fitted only for jobs in which—in spite of the general rise in wage rates—they earn less than before.

All these changes in the prices of the factors of production begin immediately with the initiation of the entrepreneurial actions designed to adjust the processes of production to the new state of affairs. In dealing with this problem as with the other problems of changes in the market data, we must guard ourselves against the popular fallacy of drawing a sharp line between short-run and long-run effects. What happens in the short run is precisely the first stages of the chain of successive transformations which tend to bring about the long-run effects. The long-run effect is in our case the disappearance of entrepreneurial profits and losses. The short-run effects are the preliminary stages of this process of elimination which finally, if not interrupted by a further change in the data, would result in the emergence of the evenly rotating economy.

It is necessary to comprehend that the very appearance of an excess in the total amount of entrepreneurial profits over the total amount of entrepreneurial losses depends upon the fact that this process of the elimination of entrepreneurial profit and loss begins at Edition: current; Page: [297] the same time as the entrepreneurs begin to adjust the complex of production activities to the changed data. There is never in the whole sequence of events an instant in which the advantages derived from the increase in the amount of capital available and from technical improvements benefit the entrepreneurs only. If the wealth and the income of the other strata were to remain unaffected, these people could buy the additional products only by restricting their purchases of other products accordingly. Then the profits of one group of entrepreneurs would exactly equal the losses incurred by other groups.

What happens is this: The entrepreneurs embarking upon the utilization of the newly accumulated capital goods and the improved technological methods of production are in need of complementary factors of production. Their demand for these factors is a new additional demand which must raise their prices. Only as far as this rise in prices and wage rates occurs, are the consumers in a position to buy the new products without curtailing the purchase of other goods. Only so far can a surplus of the total sum of all entrepreneurial profits over all entrepreneurial losses come into existence.

The vehicle of economic progress is the accumulation of additional capital goods by means of saving and improvement in technological methods of production the execution of which is almost always conditioned by the availability of such new capital. The agents of progress are the promoting entrepreneurs intent upon profiting by means of adjusting the conduct of affairs to the best possible satisfaction of the consumers. In the performance of their projects for the realization of progress they are bound to share the benefits derived from progress with the workers and also with a part of the capitalists and landowners and to increase the portion allotted to these people step by step until their own share melts away entirely.

From this it becomes evident that it is absurd to speak of a “rate of profit” or a “normal rate of profit” or an “average rate of profit.” Profit is not related to or dependent on the amount of capital employed by the entrepreneur. Capital does not “beget” profit. Profit and loss are entirely determined by the success or failure of the entrepreneur to adjust production to the demand of the consumers. There is nothing “normal” in profits and there can never be an “equilibrium” with regard to them. Profit and loss are, on the contrary, always a phenomenon of a deviation from “normalcy,” of changes unforeseen by the majority, and of a “disequilibrium.” They have no place in an imaginary world of normalcy and equilibrium. In a changing economy there prevails always an inherent tendency Edition: current; Page: [298] for profits and losses to disappear. It is only the emergence of new changes which revives them again. Under stationary conditions the “average rate” of profits and losses is zero. An excess of the total amount of profits over that of losses is a proof of the fact that there is economic progress and an improvement in the standard of living of all strata of the population. The greater this excess is, the greater is the increment in general prosperity.

Many people are utterly unfit to deal with the phenomenon of entrepreneurial profit without indulging in envious resentment. In their eyes the source of profit is exploitation of the wage earners and the consumers, i.e., an unfair reduction in wage rates and a no less unfair increase in the prices of the products. By rights there should not be any profits at all.

Economics is indifferent with regard to such arbitrary value judgments. It is not interested in the problem of whether profits are to be approved or condemned from the point of view of an alleged natural law and of an alleged eternal and immutable code of morality about which personal intuition or divine revelation are supposed to convey precise information. Economics merely establishes the fact that entrepreneurial profits and losses are essential phenomena of the market economy. There cannot be a market economy without them. It is certainly possible for the police to confiscate all profits. But such a policy would by necessity convert the market economy into a senseless chaos. Man has, there is no doubt, the power to destroy many things, and he has made in the course of history ample use of this faculty. He could destroy the market economy too.

If those self-styled moralists were not blinded by their envy, they would not deal with profit without dealing simultaneously with its corollary, loss. They would not pass over in silence the fact that the preliminary conditions of economic improvement are an achievement of those whose saving accumulates the additional capital goods and of the inventors, and that the utilization of these conditions for the realization of economic improvement is effected by the entrepreneurs. The rest of the people do not contribute to progress, but they are benefited by the horn of plenty which other people’s activities pour upon them.

What has been said about the progressing economy is mutatis mutandis to be applied to the conditions of a retrogressing economy, i.e., an economy in which the per capita quota of capital invested is decreasing. In such an economy there is an excess in the total sum of entrepreneurial losses over that of profits. People who cannot free themselves from the fallacy of thinking in concepts of collectives Edition: current; Page: [299] and whole groups might raise the question of how in such a retrogressing economy there could be any entrepreneurial activity at all. Why should anybody embark upon an enterprise if he knows in advance that mathematically his chances of earning profits are smaller than those of suffering losses? However, this mode of posing the problem is fallacious. Like everyone else, entrepreneurs do not act as members of a class, but as individuals. No entrepreneur bothers a whit about the fate of the totality of the entrepreneurs. It is irrelevant to the individual entrepreneur what happens to other people whom theories, according to a certain characteristic, assign to the same class they assign him. In the living, perpetually changing market society there are always profits to be earned by efficient entrepreneurs. The fact that in a retrogressing economy the total amount of losses exceeds the total amount of profits does not deter a man who has confidence in his own superior efficiency. A prospective entrepreneur does not consult the calculus of probability which is of no avail in the field of understanding. He trusts his own ability to understand future market conditions better than his less gifted fellow men.

The entrepreneurial function, the striving of entrepreneurs after profits, is the driving power in the market economy. Profit and loss are the devices by means of which the consumers exercise their supremacy on the market. The behavior of the consumers makes profits and losses appear and thereby shifts ownership of the means of production from the hands of the less efficient into those of the more efficient. It makes a man the more influential in the direction of business activities the better he succeeds in serving the consumers. In the absence of profit and loss the entrepreneurs would not know what the most urgent needs of the consumers are. If some entrepreneurs were to guess it, they would lack the means to adjust production accordingly.

Profit-seeking business is subject to the sovereignty of the consumers, while nonprofit institutions are sovereign unto themselves and not responsible to the public. Production for profit is necessarily production for use, as profits can only be earned by providing the consumers with those things they most urgently want to use.

The moralists’ and sermonizers’ critique of profits misses the point. It is not the fault of the entrepreneurs that the consumers—the people, the common man—prefer liquor to Bibles and detective stories to serious books, and that governments prefer guns to butter. The entrepreneur does not make greater profits in selling “bad” things than in selling “good” things. His profits are the greater the better he succeeds in providing the consumers with those things they ask for Edition: current; Page: [300] most intensely. People do not drink intoxicating beverages in order to make the “alcohol capital” happy, and they do not go to war in order to increase the profits of the “merchants of death.” The existence of the armaments industries is a consequence of the warlike spirit, not its cause.

It is not the business of the entrepreneurs to make people substitute sound ideologies for unsound. It rests with the philosophers to change people’s ideas and ideals. The entrepreneur serves the consumers as they are today, however wicked and ignorant.

We may admire those who abstain from making gains they could reap in producing deadly weapons or hard liquor. However, their laudable conduct is a mere gesture without any practical effects. Even if all entrepreneurs and capitalists were to follow their example, wars and dipsomania would not disappear. As was the case in the precapitalistic ages, governments would produce the weapons in their own arsenals and drinkers would distill their own liquor.

The Moral Condemnation of Profit

Profit is earned by the adjustment of the utilization of the human and material factors of production to changes in conditions. It is those benefited by this adjustment who, scrambling for the products concerned and offering and paying for them prices that exceed the costs expended by the seller, generate the profits. Entrepreneurial profit is not a “reward” granted by the customer to the supplier who served him better than the sluggish routinists; it is the result of the eagerness of the buyers to outbid others who are equally anxious to acquire a share of the limited supply.

The dividends of corporations are popularly called profits. Actually they are interest on the capital invested plus that part of profits that is not ploughed back into the enterprise. If the enterprise does not operate successfully, either no dividends are paid or the dividends contain only interest on the whole or a part of the capital.

Socialists and interventionists call profit and interest unearned income, the result of depriving the workers of a considerable part of the fruits of their effort. As they see it, the products come into existence through toiling as such and nothing else, and should by rights benefit the toilers alone.

Yet bare labor produces very little if not aided by the employment of the outcome of previous saving and accumulation of capital. The products are the outgrowth of a cooperation of labor with tools and other capital goods directed by provident entrepreneurial design. The savers, whose saving accumulated and maintains the capital, and the entrepreneurs, who channel the capital into those employments in which it best serves the consumers, are no less indispensable for the Edition: current; Page: [301] process of production than the toilers. It is nonsensical to impute the whole product to the purveyors of labor and to pass over in silence the contribution of the purveyors of capital and of entrepreneurial ideas. What brings forth usable goods is not physical effort as such, but physical effort aptly directed by the human mind toward a definite goal. The greater (with the advance of general well-being) the role of capital goods, and the more efficient their utilization in the cooperation of the factors of production, the more absurd becomes the romantic glorification of the mere performing of manual routine jobs. The marvelous economic improvements of the last two hundred years were an achievement of the capitalists who provided the capital goods required and of the elite of technologists and entrepreneurs. The masses of the manual workers were benefited by changes which they not only did not generate but which, more often than not, they tried to cut short.

Some Observations on the Underconsumption Bogey and on the Purchasing Power Argument

In speaking of underconsumption, people mean to describe a state of affairs in which a part of the goods produced cannot be consumed because the people who could consume them are by their poverty prevented from buying them. These goods remain unsold or can be swapped only at prices not covering the cost of production. Hence various disarrangements and disturbances arise, the total complex of which is called economic depression.

Now it happens again and again that entrepreneurs err in anticipating the future state of the market. Instead of producing those goods for which the demand of the consumers is most intense, they produce less urgently needed goods or things which cannot be sold at all. These inefficient entrepreneurs suffer losses while their more efficient competitors who anticipated the wishes of the consumers earn profits. The losses of the former group of entrepreneurs are not caused by a general abstention from buying on the part of the public; they are due to the fact that the public prefers to buy other goods.

If it were true, as the underconsumption myth implies, that the workers are too poor to buy the products because the entrepreneurs and the capitalists unfairly appropriate to themselves what by rights should go to the wage earners, the state of affairs would not be altered. The “exploiters” are not supposed to exploit from sheer wantonness. They want, it is insinuated, to increase at the expense of the “exploited” either their own consumption or their own investments. They do not withdraw their booty from the universe. They spend it either in buying luxuries for their own household or in buying producers’ goods for the expansion of their enterprises. Of course, their demand is directed toward goods other than those the wage earners would have bought if the profits had been confiscated and distributed among them. Edition: current; Page: [302] Entrepreneurial errors with regard to the state of the market of various classes of commodities as created by such “exploitation” are in no way different from any other entrepreneurial shortcomings. Entrepreneurial errors result in losses for the inefficient entrepreneurs which are counterbalanced by the profits of the efficient entrepreneurs. They make business bad for some groups of industries and good for other groups. They do not bring about a general depression of trade.

The underconsumption myth is baseless self-contradictory balderdash. Its reasoning crumbles away as soon as one begins to examine it. It is untenable even if one, for the sake of argument, accepts the “exploitation” doctrine as correct.

The purchasing power argument runs in a slightly different manner. It contends that a rise in wage rates is a prerequisite of the expansion of production. If wage rates do not rise, there is no use for business to increase the quantity and to improve the quality of the goods produced. For the additional products would find no buyers or only such buyers as restrict their purchases of other goods. What is needed first for the realization of economic progress is to make wage rates rise continually. Government or labor union pressure and compulsion aiming at the enforcement of higher wage rates are the main vehicles of progress.

As has been demonstrated above the emergence of an excess in the total sum of entrepreneurial profits over the total sum of entrepreneurial losses is inseparably bound up with the fact that a portion of the benefits derived from the increase in the quantity of capital goods available and from the improvement of technological procedures goes to the nonentrepreneurial groups. The rise in the prices of complementary factors of production, first among them wage rates, is neither a concession which the entrepreneurs willy-nilly must make to the rest of the people nor a clever device of the entrepreneurs in order to make profits. It is an unavoidable and necessary phenomenon in the chain of successive events which the endeavors of the entrepreneurs to make profits by adjusting the supply of the consumers’ goods to the new state of affairs are bound to bring about. The same process which results in an excess of entrepreneurial profits over losses causes first—i.e., before such an excess appears—the emergence of a tendency toward a rise in wage rates and in the prices of many material factors of production. And it is again the same process that would in the further course of events make this excess of profits over losses disappear, provided that no further changes, increasing the amount of capital goods available, were to occur. The excess of profits over losses is not a consequence of the rise in the prices of the factors of production. The two phenomena—the rise in the prices of the factors of production and the excess of profits over losses—are both steps in the process of adjustment of production to the increase in the quantity of capital goods and to the technological changes which the Edition: current; Page: [303] entrepreneurial actions actuate. Only to the extent that the other strata of the population are enriched by this adjustment can an excess of profits over losses temporarily come into being.

The basic error of the purchasing power argument consists in misconstruing this causal relation. It turns things upside down when considering the rise in wage rates as the force bringing about economic improvement.

We will discuss at a later stage of this book the consequences of the attempts of the governments and of organized labor violence to enforce wage rates higher than those determined by a nonhampered market.24 Here we must only add one more explanatory remark.

When speaking of profits and losses, prices and wage rates, what we have in mind is always real profits and losses, real prices and real wage rates. It is the arbitrary interchange of money terms and real terms that has led many people astray. This problem too will be dealt with exhaustively in later chapters. Let us incidentally only mention the fact that a rise in real wage rates is compatible with a drop in nominal wage rates.

10: Promoters, Managers, Technicians, and Bureaucrats

The entrepreneur hires the technicians, i.e., people who have the ability and the skill to perform definite kinds and quantities of work. The class of technicians includes the great inventors, the champions in the field of applied science, the constructors and designers as well as the performers of the most simple tasks. The entrepreneur joins their ranks as far as he himself takes part in the technical execution of his entrepreneurial plans. The technician contributes his own toil and trouble; but it is the entrepreneur qua entrepreneur who directs his labor toward definite goals. And the entrepreneur himself acts as a mandatary, as it were, of the consumers.

The entrepreneurs are not omnipresent. They cannot themselves attend to the manifold tasks which are incumbent upon them. Adjustment of production to the best possible supplying of the consumers with the goods they are asking for most urgently does not merely consist in determining the general plan for the utilization of resources. There is, of course, no doubt that this is the main function of the promoter and speculator. But besides the great adjustments, many small adjustments are necessary too. Each of them may seem trifling and of little bearing upon the total result. But the cumulative effect of shortcomings in many of these minor matters can be such as to frustrate entirely the success of a correct solution of the great problems. At any rate, it is certain that every failure to handle the smaller Edition: current; Page: [304] problems results in a squandering of scarce factors of production and consequently in impairing the best possible satisfaction of the consumers.

It is important to conceive in what respects the problem we have in mind differs from the technological tasks of the technicians. The execution of every project upon which the entrepreneur has embarked in making his decision with regard to the general plan of action requires a multiplicity of minute decisions. Each of these decisions must be effected in such a way as to prefer that solution of the problem which—without interfering with the designs of the general plan for the whole project—is the most economical one. It must avoid superfluous costs in the same way as does the general plan. The technician from his purely technological point of view either may not see any difference in the alternatives offered by various methods for the solution of such a detail or may give preference to one of these methods on account of its greater output in physical quantities. But the entrepreneur is actuated by the profit motive. This enjoins upon him the urge to prefer the most economical solution, i.e., that solution which avoids employing factors of production whose employment would impair the satisfaction of the more intensely felt wants of the consumers. He will prefer among the various methods, with regard to which the technicians are neutral, the one the application of which requires the smallest cost. He may reject the technicians’ suggestion to choose a more costly method securing a greater physical output if his calculation shows that the increase in output would not outweigh the increase in cost required. Not only in the great decisions and plans but no less in the daily decisions of small problems as they turn up in the current conduct of affairs, the entrepreneur must perform his task of adjusting production to the demand of the consumers as reflected in the prices of the market.

Economic calculation as practiced in the market economy, and especially the system of double-entry bookkeeping, make it possible to relieve the entrepreneur of involvement in too much detail. He can devote himself to his great tasks without being entangled in a multitude of trifles beyond any mortal man’s range of sight. He can appoint assistants to whose solicitude he entrusts the care of subordinate entrepreneurial duties. And these assistants in their turn can be aided according to the same principle by assistants appointed for a smaller sphere of duties. In this way a whole managerial hierarchy can be built up.

A manager is a junior partner of the entrepreneur, as it were, no matter what the contractual and financial terms of his employment Edition: current; Page: [305] are. The only relevant thing is that his own financial interests force him to attend to the best of his abilities to the entrepreneurial functions which are assigned to him within a limited and precisely determined sphere of action.

It is the system of double-entry bookkeeping that makes the functioning of the managerial system possible. Thanks to it, the entrepreneur is in a position to separate the calculation of each part of his total enterprise in such a way that he can determine the role it plays within his whole enterprise. Thus he can look at each section as if it were a separate entity and can appraise it according to the share it contributes to the success of the total enterprise. Within this system of business calculation each section of a firm represents an integral entity, a hypothetical independent business, as it were. It is assumed that this section “owns” a definite part of the whole capital employed in the enterprise, that it buys from other sections and sells to them, that it has its own expenses and its own revenues, that its dealings result either in a profit or in a loss which is imputed to its own conduct of affairs as distinguished from the result of the other sections. Thus the entrepreneur can assign to each section’s management a great deal of independence. The only directive he gives to a man whom he entrusts with the management of a circumscribed job is to make as much profit as possible. An examination of the accounts shows how successful or unsuccessful the managers were in executing this directive. Every manager and submanager is responsible for the working of his section or subsection. It is to his credit if the accounts show a profit, and it is to his disadvantage if they show a loss. His own interests impel him toward the utmost care and exertion in the conduct of his section’s affairs. If he incurs losses, he will be replaced by a man whom the entrepreneur expects to be more successful, or the whole section will be discontinued. At any rate, the manager will lose his job. If he succeeds in making profits, his income will be increased, or at least he will not be in danger of losing it. Whether or not a manager is entitled to a share in the profit imputed to his section is not important with regard to the personal interest he takes in the results of his section’s dealings. His welfare is at any rate closely connected with that of his section. His task is not like that of the technician, to perform a definite piece of work according to a definite precept. It is to adjust—within the limited scope left to his discretion—the operation of his section to the state of the market. Of course, just as an entrepreneur may combine in his person entrepreneurial functions and those of a technician, such a union of various functions can also occur with a manager.

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The managerial function is always subservient to the entrepreneurial function. It can relieve the entrepreneur of a part of his minor duties; it can never evolve into a substitute for entrepreneurship. The fallacy to the contrary is due to the error confusing the category of entrepreneurship as it is defined in the imaginary construction of functional distribution with conditions in a living and operating market economy. The function of the entrepreneur cannot be separated from the direction of the employment of factors of production for the accomplishment of definite tasks. The entrepreneur controls the factors of production; it is this control that brings him either entrepreneurial profit or loss.

It is possible to reward the manager by paying for his services in proportion to the contribution of his section to the profit earned by the entrepreneur. But this is of no avail. As has been pointed out, the manager is under any circumstances interested in the success of that part of the business which is entrusted to his care. But the manager cannot be made answerable for the losses incurred. These losses are suffered by the owners of the capital employed. They cannot be shifted to the manager.

Society can freely leave the care for the best possible employment of capital goods to their owners. In embarking upon definite projects these owners expose their own property, wealth, and social position. They are even more interested in the success of their entrepreneurial activities than is society as a whole. For society as a whole the squandering of capital invested in a definite project means only the loss of a small part of its total funds; for the owner it means much more, for the most part the loss of his total fortune. But if a manager is given a completely free hand, things are different. He speculates in risking other people’s money. He sees the prospects of an uncertain enterprise from another angle than that of the man who is answerable for the losses. It is precisely when he is rewarded by a share of the profits that he becomes foolhardy because he does not share in the losses too.

The illusion that management is the totality of entrepreneurial activities and that management is a perfect substitute for entrepreneurship is the outgrowth of a misinterpretation of the conditions of the corporations, the typical form of present-day business. It is asserted that the corporation is operated by the salaried managers, while the shareholders are merely passive spectators. All the powers are concentrated in the hands of hired employees. The shareholders are idle and useless; they harvest what the managers have sown.

This doctrine disregards entirely the role that the capital and money market, the stock and bond exchange, which a pertinent Edition: current; Page: [307] idiom simply calls the “market,” plays in the direction of corporate business. The dealings of this market are branded by popular anticapitalistic bias as a hazardous game, as mere gambling. In fact, the changes in the prices of common and preferred stock and of corporate bonds are the means applied by the capitalists for the supreme control of the flow of capital. The price structure as determined by the speculations on the capital and money markets and on the big commodity exchanges not only decides how much capital is available for the conduct of each corporation’s business; it creates a state of affairs to which the managers must adjust their operations in detail.

The general direction of a corporation’s conduct of business is exercised by the stockholders and their elected mandataries, the directors. The directors appoint and discharge the managers. In smaller companies and sometimes even in bigger ones the offices of the directors and the managers are often combined in the same persons. A successful corporation is ultimately never controlled by hired managers. The emergence of an omnipotent managerial class is not a phenomenon of the unhampered market economy. It was, on the contrary, an outgrowth of the interventionist policies consciously aiming at an elimination of the influence of the shareholders and at their virtual expropriation. In Germany, Italy, and Austria it was a preliminary step on the way toward the substitution of government control of business for free enterprise, as has been the case in Great Britain with regard to the Bank of England and the railroads. Similar tendencies are prevalent in the American public utilities. The marvelous achievements of corporate business were not a result of the activities of a salaried managerial oligarchy; they were accomplished by people who were connected with the corporation by means of the ownership of a considerable part or of the greater part of its stock and whom part of the public scorned as promoters and profiteers.

The entrepreneur determines alone, without any managerial interference, in what lines of business to employ capital and how much capital to employ. He determines the expansion and contraction of the size of the total business and its main sections. He determines the enterprise’s financial structure. These are the essential decisions which are instrumental in the conduct of business. They always fall upon the entrepreneur, in corporations as well as in other types of a firm’s legal structure. Any assistance given to the entrepreneur in this regard is of ancillary character only; he takes information about the past state of affairs from experts in the fields of law, statistics, and technology; but the final decision implying a judgment about the future state of the market rests with him alone. The execution of the Edition: current; Page: [308] details of his projects may then be entrusted to managers.

The social functions of the managerial elite are no less indispensable for the operation of the market economy than are the functions of the elite of inventors, technologists, engineers, designers, scientists, and experimenters. In the ranks of the managers many of the most eminent men serve the cause of economic progress. Successful managers are remunerated by high salaries and often by a share in the enterprise’s gross profits. Many of them in the course of their careers become themselves capitalists and entrepreneurs. Nonetheless, the managerial function is different from the entrepreneurial function.

It is a serious mistake to identify entrepreneurship with management as in the popular antithesis of “management” and “labor.” This confusion is, of course, intentional. It is designed to obscure the fact that the functions of entrepreneurship are entirely different from those of the managers attending to the minor details of the conduct of business. The structure of business, the allocation of capital to the various branches of production and firms, the size and the line of operation of each plant and shop are considered as given facts and it is implied that no further changes will be effected with regard to them. The only task is to go on in the old routine. In such a stationary world, of course, there is no need for innovators and promoters; the total amount of profits is counterbalanced by the total amount of losses. To explode the fallacies of this doctrine it is enough to compare the structure of American business in 1960 with that of 1940.

But even in a stationary world it would be nonsensical to give “labor,” as a popular slogan demands, a share in management. The realization of such a postulate would result in syndicalism.25

There is furthermore a readiness to confuse the manager with a bureaucrat. Bureaucratic management, as distinguished from profit management, is the method applied in the conduct of administrative affairs, the result of which has no cash value on the market. The successful performance of the duties entrusted to the care of a police department is of the greatest importance for the preservation of social cooperation and benefits each member of society. But it has no price on the market, it cannot be bought or sold; it can therefore not be confronted with the expenses incurred in the endeavors to secure it. It results in gains, but these gains are not reflected in profits liable to expression in terms of money. The methods of economic calculation, and especially those of double-entry bookkeeping, are not applicable Edition: current; Page: [309] to them. Success or failure of a police department’s activities cannot be ascertained according to the arithmetical procedures of profit-seeking business. No accountant can establish whether or not a police department or one of its subdivisions has succeeded.

The amount of money to be expended in every branch of profitseeking business is determined by the behavior of the consumers. If the automobile industry were to treble the capital employed, it would certainly improve the services it renders to the public. There would be more cars available. But this expansion of the industry would withhold capital from other branches of production in which it could fill more urgent wants of the consumers. This fact would render the expansion of the automobile industry unprofitable and increase profits in other branches of business. In their endeavors to strive after the highest profit obtainable, entrepreneurs are forced to allocate to each branch of business only as much capital as can be employed in it without impairing the satisfaction of more urgent wants of the consumers. Thus the entrepreneurial activities are automatically, as it were, directed by the consumers’ wishes as they are reflected in the price structure of consumers’ goods.

No such limitation is enjoined upon the allocation of funds for the performance of the tasks incumbent upon government activities. There is no doubt that the services rendered by the police department of the City of New York could be considerably improved by trebling the budgetary allocation. But the question is whether or not this improvement would be considerable enough to justify either the restriction of the services rendered by other departments—e.g., those of the department of sanitation—or the restriction of the private consumption of the taxpayers. This question cannot be answered by the accounts of the police department. These accounts provide information only about the expenses incurred. They cannot provide any information about the results obtained, as these results cannot be expressed in money equivalents. The citizens must directly determine the amount of services they want to get and are ready to pay for. They discharge this task by electing councilmen and officeholders who are prepared to comply with their intentions.

Thus the mayor and the chiefs of the city’s various departments are restricted by the budget. They are not free to act upon what they themselves consider the most beneficial solution of the various problems the citizenry has to face. They are bound to spend the funds allocated for the purposes the budget has assigned them. They must not use them for other tasks. Auditing in the field of public administration is entirely different from that in the field of profit-seeking Edition: current; Page: [310] business. Its goal is to establish whether or not the funds allocated have been expended in strict compliance with the provisions of the budget.

In profit-seeking business the discretion of the managers and submanagers is restricted by considerations of profit and loss. The profit motive is the only directive needed to make them subservient to the wishes of the consumers. There is no need to restrict their discretion by minute instructions and rules. If they are efficient, such meddling with details would at best be superfluous, if not pernicious in tying their hands. If they are inefficient, it would not render their activities more successful. It would only provide them with a lame excuse that the failure was caused by inappropriate rules. The only instruction required is self-understood and does not need to be especially mentioned: Seek profit.

Things are different in public administration, in the conduct of government affairs. In this field the discretion of the officeholders and their subaltern aids is not restricted by considerations of profit and loss. If their supreme boss—no matter whether he is the sovereign people or a sovereign despot—were to leave them a free hand, he would renounce his own supremacy in their favor. These officers would become irresponsible agents, and their power would supersede that of the people or the despot. They would do what pleased them, not what their bosses wanted them to do. To prevent this outcome and to make them subservient to the will of their bosses, it is necessary to give them detailed instructions regulating their conduct of affairs in every respect. Then it becomes their duty to handle all affairs in strict compliance with these rules and regulations. Their freedom to adjust their acts to what seems to them the most appropriate solution of a concrete problem is limited by these norms. They are bureaucrats, i.e., men who in every instance must observe a set of inflexible regulations.

Bureaucratic conduct of affairs is conduct bound to comply with detailed rules and regulations fixed by the authority of a superior body. It is the only alternative to profit management. Profit management is inapplicable in the pursuit of affairs which have no cash value on the market and in the non-profit conduct of affairs which could also be operated on a profit basis. The former is the case of the administration of the social apparatus of coercion and compulsion; the latter is the case in the conduct of an institution on a non-profit basis, e.g., a school, a hospital, or a postal system. Whenever the operation of a system is not directed by the profit motive, it must be directed by bureaucratic rules.

Bureaucratic conduct of affairs is, as such, not an evil. It is the only Edition: current; Page: [311] appropriate method of handling governmental affairs, i.e., the social apparatus of compulsion and coercion. As government is necessary, bureaucratism is—in this field—no less necessary. Where economic calculation is unfeasible, bureaucratic methods are indispensable. A socialist government must apply them to all affairs.

No business, whatever its size or specific task, can ever become bureaucratic so long as it is entirely and solely operated on a profit basis. But as soon as it abandons profit seeking and substitutes for it what is called the service principle—i.e., the rendering of services without regard as to whether or not the prices to be obtained for them cover the expenses—it must substitute bureaucratic methods for those of entrepreneurial management.26

11: The Selective Process

The selective process of the market is actuated by the composite effort of all members of the market economy. Driven by the urge to remove his own uneasiness as much as possible, each individual is intent, on the one hand, upon attaining that position in which he can contribute most to the best satisfaction of everyone else and, on the other hand, upon taking best advantage of the services offered by everyone else. This means that he tries to sell on the dearest market and to buy on the cheapest market. The resultant of these endeavors is not only the price structure but no less the social structure, the assignment of definite tasks to the various individuals. The market makes people rich or poor, determines who shall run the big plants and who shall scrub the floors, fixes how many people shall work in the copper mines and how many in the symphony orchestras. None of these decisions is made once and for all; they are revocable every day. The selective process never stops. It goes on adjusting the social apparatus of production to the changes in demand and supply. It reviews again and again its previous decisions and forces everybody to submit to a new examination of his case. There is no security and no such thing as a right to preserve any position acquired in the past. Nobody is exempt from the law of the market, the consumers’ sovereignty.

Ownership of the means of production is not a privilege, but a social liability. Capitalists and landowners are compelled to employ their property for the best possible satisfaction of the consumers. If they are slow and inept in the performance of their duties, they are penalized by losses. If they do not learn the lesson and do not Edition: current; Page: [312] reform their conduct of affairs, they lose their wealth. No investment is safe forever. He who does not use his property in serving the consumers in the most efficient way is doomed to failure. There is no room left for people who would like to enjoy their fortunes in idleness and thoughtlessness. The proprietor must aim to invest his funds in such a way that principal and yield are at least not impaired.

In the ages of caste privileges and trade barriers there were revenues not dependent on the market. Princes and lords lived at the expense of the humble slaves and serfs who owed them tithes, statute labor, and tributes. Ownership of land could only be acquired either by conquest or by largesse on the part of a conqueror. It could be forfeited only by recantation on the part of the donor or by conquest on the part of another conqueror. Even later, when the lords and their liegemen began to sell their surpluses on the market, they could not be ousted by the competition of more efficient people. Competition was free only within very narrow limits. The acquisition of manorial estates was reserved to the nobility, that of urban real property to the citizens of the township, that of farm land to the peasants. Competition in the arts and crafts was restricted by the guilds. The consumers were not in a position to satisfy their wants in the cheapest way, as price control made underbidding impossible to the sellers. The buyers were at the mercy of their purveyors. If the privileged producers refused to resort to the employment of the most adequate raw materials and of the most efficient methods of processing, the consumers were forced to endure the consequences of such stubbornness and conservatism.

The landowner who lives in perfect self-sufficiency from the fruits of his own farming is independent of the market. But the modern farmer who buys equipment, fertilizers, seed, labor, and other factors of production and sells agricultural products is subject to the law of the market. His income depends on the consumers and he must adjust his operations to their wishes.

The selective function of the market works also with regard to labor. The worker is attracted by that kind of work in which he can expect to earn most. As is the case with material factors of production, the factor labor too is allocated to those employments in which it best serves the consumers. There prevails the tendency not to waste any quantity of labor for the satisfaction of less urgent demand if more urgent demand is still unsatisfied. Like all other strata of society, the worker is subject to the supremacy of the consumers. If he disobeys, he is penalized by a cut in earnings.

The selection of the market does not establish social orders, castes, Edition: current; Page: [313] or classes in the Marxian sense. Nor do the entrepreneurs and promoters form an integrated social class. Each individual is free to become a promoter if he relies upon his own ability to anticipate future market conditions better than his fellow citizens and if his attempts to act at his own peril and on his own responsibility are approved by the consumers. One enters the ranks of the promoters by spontaneously pushing forward and thus submitting to the trial to which the market subjects, without respect for persons, everybody who wants to become a promoter or to remain in this eminent position. Everybody has the opportunity to take his chance. A newcomer does not need to wait for an invitation or encouragement from anyone. He must leap forward on his own account and must himself know how to provide the means needed.

It has been contended again and again that under the conditions of “late” or “mature” capitalism it is no longer possible for penniless people to climb the ladder to wealth and entrepreneurial position. No attempt has ever been made to prove this thesis. Since it was first advanced, the composition of the entrepreneurial and capitalist groups has changed considerably. A great part of the former entrepreneurs and their heirs have been eliminated and other people, newcomers, have taken their places. It is, of course, true that in the last years institutions have been purposely developed which, if not abolished very soon, will make the functioning of the market in every regard impossible.

The point of view from which the consumers choose the captains of industry and business is exclusively their qualification to adjust production to the needs of the consumers. They do not bother about other features and merits. They want a shoe manufacturer to fabricate good and cheap shoes. They are not intent upon entrusting the conduct of the shoe trade to handsome amiable boys, to people of good drawing-room manners, of artistic gifts, of scholarly habits, or of any other virtues or talents. A proficient businessman may often be deficient in many accomplishments which contribute to the success of a man in other spheres of life.

It is quite common nowadays to deprecate the capitalists and entrepreneurs. A man is prone to sneer at those who are more prosperous than himself. These people, he contends, are richer only because they are less scrupulous than he. If he were not restrained by due consideration for the laws of morality and decency, he would be no less successful than they are. Thus men glory in the aureole of self-complacency and Pharisaic self-righteousness.

Now it is true that under the conditions brought about by interventionism Edition: current; Page: [314] many people can acquire wealth by graft and bribery. In many countries interventionism has so undermined the supremacy of the market that it is more advantageous for a businessman to rely upon the aid of those in political office than upon the best satisfaction of the needs of the consumers. But it is not this that the popular critics of other people’s wealth have in mind. They contend that the methods by which wealth is acquired in a pure market society are objectionable from the ethical point of view.

Against such statements it is necessary to emphasize that, so far as the operation of the market is not sabotaged by the interference of governments and other factors of coercion, success in business is the proof of services rendered to the consumers. The poor man need not be inferior to the prosperous businessman in other regards; he may sometimes be outstanding in scientific, literary, and artistic achievements or in civic leadership. But in the social system of production he is inferior. The creative genius may be right in his disdain for commercial success; it may be true that he would have been prosperous in business if he had not preferred other things. But the clerks and workers who boast of their moral superiority deceive themselves and find consolation in this self-deception. They do not admit that they have been tried and found wanting by their fellow citizens, the consumers.

It is often asserted that the poor man’s failure in the competition of the market is caused by his lack of education. Equality of opportunity, it is said, could be provided only by making education at every level accessible to all. There prevails today the tendency to reduce all differences among various peoples to their education and to deny the existence of inborn inequalities in intellect, will power, and character. It is not generally realized that education can never be more than indoctrination with theories and ideas already developed. Education, whatever benefits it may confer, is transmission of traditional doctrines and valuations; it is by necessity conservative. It produces imitation and routine, not improvement and progress. Innovators and creative geniuses cannot be reared in schools. They are precisely the men who defy what the school has taught them.

In order to succeed in business a man does not need a degree from a school of business administration. These schools train the subalterns for routine jobs. They certainly do not train entrepreneurs. An entrepreneur cannot be trained. A man becomes an entrepreneur in seizing an opportunity and filling the gap. No special education is required for such a display of keen judgment, foresight, and energy. The most successful businessmen were often uneducated when measured by the scholastic standards of the teaching profession. But they were equal Edition: current; Page: [315] to their social function of adjusting production to the most urgent demand. Because of these merits the consumers chose them for business leadership.

12: The Individual and the Market

It is customary to speak metaphorically of the automatic and anonymous forces actuating the “mechanism” of the market. In employing such metaphors people are ready to disregard the fact that the only factors directing the market and the determination of prices are purposive acts of men. There is no automatism; there are only men consciously and deliberately aiming at ends chosen. There are no mysterious mechanical forces; there is only the human will to remove uneasiness. There is no anonymity; there are you and I and Bill and Joe and all the rest. And each of us is both a producer and a consumer.

The market is a social body; it is the foremost social body. The market phenomena are social phenomena. They are the resultant of each individual’s active contribution. But they are different from each such contribution. They appear to the individual as something given which he himself cannot alter. He does not always see that he himself is a part, although a small part, of the complex of elements determining each momentary state of the market. Because he fails to realize this fact, he feels himself free, in criticizing the market phenomena, to condemn with regard to his fellow men a mode of conduct which he considers as quite right with regard to himself. He blames the market for its callousness and disregard of persons and asks for social control of the market in order to “humanize” it. He asks on the one hand for measures to protect the consumer against the producers. But on the other hand he insists even more passionately upon the necessity of protecting himself as a producer against the consumers. The outcome of these contradictory demands is the modern methods of government interference whose most outstanding examples were the Sozialpolitik of imperial Germany and the American New Deal.

It is an old fallacy that it is a legitimate task of civil government to protect the less efficient producer against the competition of the more efficient. One asks for a “producers’ policy” as distinct from a “consumers’ policy.” While flamboyantly repeating the truism that the only aim of production is to provide ample supplies for consumption, people emphasize with no less eloquence that the “industrious” producer should be protected against the “idle” consumer.

However, producers and consumers are identical. Production and Edition: current; Page: [316] consumption are different stages in acting. Catallactics embodies these differences in speaking of producers and consumers. But in reality they are the same people. It is, of course, possible to protect a less efficient producer against the competition of more efficient fellows. Such a privilege conveys to the privileged the benefits which the unhampered market provides only to those who succeed in best filling the wants of the consumers. But it necessarily impairs the satisfaction of the consumers. If only one producer or a small group is privileged, the beneficiaries enjoy an advantage at the expense of the rest of the people. But if all producers are privileged to the same extent, everybody loses in his capacity as consumer as much as he gains in his capacity as a producer. Moreover, all are injured because the supply of products drops if the most efficient men are prevented from employing their skill in that field in which they could render the best services to the consumers.

If a consumer believes that it is expedient or right to pay a higher price for domestic cereals than for cereals imported from abroad, or for manufactures processed in plants operated by small business or employing unionized workers than for those of another provenance, he is free to do so. He would only have to satisfy himself that the commodity offered for sale meets the conditions upon which he makes the allowance of a higher price depend. Laws which forbid counterfeiting of labels of origin and trademarks would succeed in attaining the ends aimed at by tariffs, labor legislation, and privileges granted to small business. But it is beyond doubt that the consumers are not prepared to act in this way. The fact that a commodity is marked as imported does not impair its salability if it is better or cheaper, or both. As a rule the buyers want to buy as cheaply as possible without regard for the origin of the article or some particular characteristics of the producers.

The psychological root of the producers’ policy as practiced today in all parts of the world is to be seen in spurious economic doctrines. These doctrines flatly deny that the privileges granted to less efficient producers burden the consumer. Their advocates contend that such measures are prejudicial only to those against whom they discriminate. When pressed further, they are forced to admit that the consumers are damaged too, they maintain that the losses of the consumers are more than compensated by an increase in their money income which the measures in question are bound to bring about.

Thus in the predominantly industrial countries of Europe the protectionists were first eager to declare that the tariff on agricultural products hurts exclusively the interests of the farmers of the predominantly Edition: current; Page: [317] agricultural countries and of the grain dealers. It is certain that these exporting interests are damaged too. But it is no less certain that the consumers of the country that adopts the tariff policy are losing with them. They must pay higher prices for their food. Of course, the protectionist retorts, that this is not a burden. For, he argues, the additional amount that the domestic consumer pays increases the farmers’ income and their purchasing power; they will spend the whole surplus in buying more of the products manufactured by the nonagricultural strata of the population. This paralogism can easily be exploded by referring to the well-known anecdote of the man who asks an innkeeper for a gift of ten dollars; it will not cost him anything because the beggar promises to spend the whole amount in his inn. But for all that, the protectionist fallacy got hold of public opinion, and this alone explains the popularity of the measures inspired by it. Many people simply do not realize that the only effect of protection is to divert production from those places in which it could produce more per unit of capital and labor expended to places in which it produces less. It makes people poorer, not more prosperous.

The ultimate foundation of modern protectionism and of the striving for economic autarky of each country is to be found in this mistaken belief that they are the best means to make every citizen, or at least the immense majority of them, richer. The term riches means in this connection an increase in the individual’s real income and an improvement in his standard of living. It is true that the policy of national economic insulation is a necessary corollary of the endeavors to interfere with domestic business, and that it is an outcome of warlike tendencies as well as one of the factors producing these tendencies. But the fact remains that it would never have been possible to sell the idea of protection to the voters if one had not been able to convince them that protection not only does not impair their standard of living but raises it considerably.

It is important to emphasize this fact because it utterly explodes a myth propagated by many popular books. According to these myths, contemporary man is no longer motivated by the desire to improve his material well-being and to raise his standard of living. The assertions of the economists to the contrary are mistaken. Modern man gives priority to “noneconomic” or “irrational” things and is ready to forego material betterment whenever its attainment stands in the way of those “ideal” concerns. It is a serious blunder, common mostly with economists and businessmen, to interpret the events of our time from an “economic” point of view and to criticize current Edition: current; Page: [318] ideologies with regard to the alleged economic fallacies implied. People long for other things more than for a good life.

It is hardly possible to misconstrue the history of our age more crassly. Our contemporaries are driven by a fanatical zeal to get more amenities and by an unrestrained appetite to enjoy life. A characteristic social phenomenon of our day is the pressure group, an alliance of people eager to promote their own material well-being by the employment of all means, legal or illegal, peaceful or violent. For the pressure group nothing matters but the increase of its members’ real income. It is not concerned with any other aspects of life. It does not bother whether or not the realization of its program hurts the vital interests of other men, of their own nation or country, and of the whole of mankind. But, of course, every pressure group is anxious to justify its demands as beneficial to the general public welfare and to stigmatize its critics as abject scoundrels, idiots, and traitors. In the pursuit of its plans it displays a quasi-religious ardor.

Without exception all political parties promise their supporters a higher real income. There is no difference in this respect between nationalists and internationalists and between the supporters of a market economy and the advocates of either socialism or interventionism. If a party asks its supporters to make sacrifices for its cause, it always explains these sacrifices as the necessary temporary means for the attainment of the ultimate goal, the improvement of the material well-being of its members. Each party considers it as an insidious plot against its prestige and its survival if somebody ventures to question the capacity of its projects to make the group members more prosperous. Each party regards with a deadly hatred the economists embarking upon such a critique.

All varieties of the producers’ policy are advocated on the ground of their alleged ability to raise the party members’ standard of living. Protectionism and economic self-sufficiency, labor union pressure and compulsion, labor legislation, minimum wage rates, public spending, credit expansion, subsidies, and other makeshifts are always recommended by their advocates as the most suitable or the only means to increase the real income of the people for whose votes they canvass. Every contemporary statesman or politician invariably tells his voters: My program will make you as affluent as conditions may permit, while my adversaries’ program will bring you want and misery.

It is true that some secluded intellectuals in their esoteric circles talk differently. They proclaim the priority of what they call eternal absolute values and feign in their declamations—not in their personal conduct—a disdain of things secular and transitory. But the public Edition: current; Page: [319] ignores such utterances. The main goal of present-day political action is to secure for the respective pressure group memberships the highest material well-being. The only way for a leader to succeed is to instill in people the conviction that his program best serves the attainment of this goal.

What is wrong with the producers’ policies is their faulty economics.

If one is prepared to indulge in the fashionable tendency to explain human things by resorting to the terminology of psychopathology, one might be tempted to say that modern man in contrasting a producers’ policy with a consumers’ policy has fallen victim to a kind of schizophrenia. He fails to realize that he is an undivided and indivisible person, i.e., an individual, and as such no less a consumer than a producer. The unity of his consciousness is split into two parts; his mind is inwardly divided against himself. But it matters little whether or not we adopt this mode of describing the fact that the economic doctrine resulting in these policies is faulty. We are not concerned with the pathological source from which an error may stem, but with the error as such and with its logical roots. The unmasking of the error by means of ratiocination is the primary fact. If a statement were not exposed as logically erroneous, psychopathology would not be in a position to qualify the state of mind from which it stems as pathological. If a man imagines himself to be the king of Siam, the first thing which the psychiatrist has to establish is whether or not he really is what he believes himself to be. Only if this question is answered in the negative can the man be considered insane.

It is true that most of our contemporaries are committed to a fallacious interpretation of the producer-consumer nexus. In buying they behave as if they were connected with the market only as buyers, and vice versa in selling. As buyers they advocate stern measures to protect them against the sellers, and as sellers they advocate no less harsh measures against the buyers. But this antisocial conduct which shakes the very foundations of social cooperation is not an outgrowth of a pathological state of mind. It is the outcome of a narrow-mindedness which fails to conceive the operation of the market economy and to anticipate the ultimate effects of one’s own actions.

It is permissible to contend that the immense majority of our contemporaries are mentally and intellectually not adjusted to life in the market society, although they themselves and their fathers have unwittingly created this society by their actions. But this maladjustment consists in nothing else than in the failure to recognize erroneous doctrines as such.

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13: Business Propaganda

The consumer is not omniscient. He does not know where he can obtain at the cheapest price what he is looking for. Very often he does not even know what kind of commodity or service is suitable to remove most efficaciously the particular uneasiness he wants to remove. At best he is familiar with the market conditions of the immediate past and arranges his plans on the basis of this information. To convey to him information about the actual state of the market is the task of business propaganda.

Business propaganda must be obtrusive and blatant. It is its aim to attract the attention of slow people, to rouse latent wishes, to entice men to substitute innovation for inert clinging to traditional routine. In order to succeed, advertising must be adjusted to the mentality of the people courted. It must suit their tastes and speak their idiom. Advertising is shrill, noisy, coarse, puffing, because the public does not react to dignified allusions. It is the bad taste of the public that forces the advertisers to display bad taste in their publicity campaigns. The art of advertising has evolved into a branch of applied psychology, a sister discipline of pedagogy.

Like all things designed to suit the taste of the masses, advertising is repellent to people of delicate feeling. This abhorrence influences the appraisal of business propaganda. Advertising and all other methods of business propaganda are condemned as one of the most outrageous outgrowths of unlimited competition. It should be forbidden. The consumers should be instructed by impartial experts; the public schools, the “nonpartisan” press, and cooperatives should perform this task.

The restriction of the right of businessmen to advertise their products would restrict the freedom of the consumers to spend their income according to their own wants and desires. It would make it impossible for them to learn as much as they can and want about the state of the market and the conditions which they may consider as relevant in choosing what to buy and what not to buy. They would no longer be in a position to decide on the basis of the opinion which they themselves have formed about the seller’s appraisal of his products; they would be forced to act on the recommendation of other people. It is not unlikely that these mentors would save them some mistakes. But the individual consumers would be under the tutelage of guardians. If advertising is not restricted, the consumers are by and large in the position of a jury which learns about the case by hearing the witnesses and examining directly all other means of Edition: current; Page: [321] evidence. If advertising is restricted, they are in the position of a jury to whom an officer reports about the result of his own examination of evidence.

It is a widespread fallacy that skillful advertising can talk the consumers into buying everything that the advertiser wants them to buy. The consumer is, according to this legend, simply defenseless against “high-pressure” advertising. If this were true, success or failure in business would depend on the mode of advertising only. However, nobody believes that any kind of advertising would have succeeded in making the candlemakers hold the field against the electric bulb, the horsedrivers against the motorcars, the goose quill against the steel pen and later against the fountain pen. But whoever admits this implies that the quality of the commodity advertised is instrumental in bringing about the success of an advertising campaign. Then there is no reason to maintain that advertising is a method of cheating the gullible public.

It is certainly possible for an advertiser to induce a man to try an article which he would not have bought if he had known its qualities beforehand. But as long as advertising is free to all competing firms, the article which is better from the point of view of the consumers’ appetites will finally outstrip the less appropriate article, whatever methods of advertising may be applied. The tricks and artifices of advertising are available to the seller of the better product no less than to the seller of the poorer product. But only the former enjoys the advantage derived from the better quality of his product.

The effects of advertising of commodities are determined by the fact that as a rule the buyer is in a position to form a correct opinion about the usefulness of an article bought. The housewife who has tried a particular brand of soap or canned food learns from experience whether it is good for her to buy and consume that product in the future too. Therefore advertising pays the advertiser only if the examination of the first sample bought does not result in the consumer’s refusal to buy more of it. It is agreed among businessmen that it does not pay to advertise products other than good ones.

Entirely different are conditions in those fields in which experience cannot teach us anything. The statements of religious, metaphysical, and political propaganda can be neither verified nor falsified by experience. With regard to the life beyond and the absolute, any experience is denied to men living in this world. In political matters experience is always the experience of complex phenomena which is open to different interpretations; the only yardstick which can be applied to political doctrines is aprioristic reasoning. Thus political Edition: current; Page: [322] propaganda and business propaganda are essentially different things, although they often resort to the same technical methods.

There are many evils for which contemporary technology and therapeutics have no remedy. There are incurable diseases and there are irreparable personal defects. It is a sad fact that some people try to exploit their fellow men’s plight by offering them patent medicines. Such quackeries do not make old people young and ugly girls pretty. They only raise hopes. It would not impair the operation of the market if the authorities were to prevent such advertising, the truth of which cannot be evidenced by the methods of the experimental natural sciences. But whoever is ready to grant to the government this power would be inconsistent if he objected to the demand to submit the statements of churches and sects to the same examination. Freedom is indivisible. As soon as one starts to restrict it, one enters upon a decline on which it is difficult to stop. If one assigns to the government the task of making truth prevail in the advertising of perfumes and toothpaste, one cannot contest it the right to look after truth in the more important matters of religion, philosophy, and social ideology.

The idea that business propaganda can force the consumers to submit to the will of the advertisers is spurious. Advertising can never succeed in supplanting better or cheaper goods by poorer goods.

The costs incurred by advertising are, from the point of view of the advertiser, a part of the total bill of production costs. A businessman expends money for advertising if and as far as he expects that the increase in sales resulting will increase the total net proceeds. In this regard there is no difference between the costs of advertising and all other costs of production. An attempt has been made to distinguish between production costs and sales costs. An increase in production costs, it has been said, increases supply, while an increase in sales costs (advertising costs included) increases demand.27 This is a mistake. All costs of production are expended with the intention of increasing demand. If the manufacturer of candy employs a better raw material, he aims at an increase in demand in the same way as he does in making the wrappings more attractive and his stores more inviting and in spending more for advertisements. In increasing production costs per unit of the product the idea is always to increase demand. If a businessman wants to increase supply, he must increase the total cost of production, which often results in lowering production costs per unit.

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14: The “Volkswirtschaft”

The market economy as such does not respect political frontiers. Its field is the world.

The term Volkswirtschaft was long applied by the German champions of government omnipotence. Only much later did the British and the French begin to speak of the “British economy” and “l’économie francaise” as distinct from the economies of other nations. But neither the English nor the French language produced an equivalent of the term Volkswirtschaft. With the modern trend toward national planning and national autarky, the doctrine involved in this German word became popular everywhere. Nonetheless, only the German language is able to express in one word all the ideas implied.

The Volkswirtschaft is a sovereign nation’s total complex of economic activities directed and controlled by the government. It is socialism realized within the political frontiers of each nation. In employing this term people are fully aware of the fact that real conditions differ from the state of affairs which they deem the only adequate and desirable state. But they judge everything that happens in the market economy from the point of view of their ideal. They assume that there is an irreconcilable conflict between the interests of the Volkswirtschaft and those of the selfish individuals eager to seek profit. They do not hesitate to assign priority to the interests of the Volkswirtschaft over those of the individuals. The righteous citizen should always place the volkswirtschaftliche interests above his own selfish interests. He should act of his own accord as if he were an officer of the government executing its orders. Gemeinnutz geht vor Eigennutz (the welfare of the nation takes precedence over the selfishness of the individuals) was the fundamental principle of Nazi economic management. But as people are too dull and too vicious to comply with this rule, it is the task of government to enforce it. The German princes of the seventeenth and eighteenth century, foremost among them the Hohenzollern Electors of Brandenburg and Kings of Prussia, were fully equal to this task. In the nineteenth century, even in Germany the liberal ideologies imported from the West superseded the well-tried and natural policies of nationalism and socialism. However, Bismarck’s and his successors’ Sozialpolitik and finally Nazism restored them.

The interests of a Volkswirtschaft are seen as implacably opposed not only to those of the individuals, but no less to those of the Volkswirtschaft of any foreign nation. The most desirable state of a Volkswirtschaft is complete economic self-sufficiency. A nation Edition: current; Page: [324] which depends on any imports from abroad lacks economic independence; its sovereignty is only a sham. Therefore a nation which cannot produce at home all that it needs is bound to conquer all the territories required. To be really sovereign and independent a nation must have Lebensraum, i.e., a territory so large and rich in natural resources that it can live in autarky at a standard no lower than that of any other nation.

Thus the idea of the Volkswirtschaft is the most radical denial of all the principles of the market economy. It was this idea that guided, more or less, the economic policies of all nations in the last decades. It was the pursuit of this idea that brought about the terrific wars of our century and may kindle still more pernicious wars in the future.

From the early beginnings of human history the two opposite principles of the market economy and of the Volkswirtschaft fought each other. Government, i.e., a social apparatus of coercion and compulsion, is a necessary requisite of peaceful cooperation. The market economy cannot do without a police power safeguarding its smooth functioning by the threat or the application of violence against peace-breakers. But the indispensable administrators and their armed satellites are always tempted to use their arms for the establishment of their own totalitarian rule. For ambitious kings and generalissimos the very existence of a sphere of the individuals’ lives not subject to regimentation is a challenge. Princes, governors, and generals are never spontaneously liberal. They become liberal only when forced to by the citizens.

The problems raised by the plans of the socialists and the interventionists will be dealt with in later parts of this book. Here we have only to answer the question of whether or not any of the essential features of the Volkswirtschaft are compatible with the market economy. For the champions of the idea of the Volkswirtschaft do not consider their scheme merely as a pattern for the establishment of a future social order. They declare emphatically that even under the system of the market economy, which, of course, in their eyes is a debased and vicious product of policies contrary to human nature, the Volkswirtschaften of the various nations are integrated units whose interests are irreconcilably opposed to those of all other nations’ Volkswirtschaften. As they see it, what separates one Volkswirtschaft from all the others is not, as the economists would have us believe, merely political institutions. It is not the trade and migration barriers established by government interference with business and the differences in legislation and in the protection granted to the individuals by the courts and tribunals that bring about the distinction Edition: current; Page: [325] between domestic trade and foreign trade. This diversity, they say, is, on the contrary, the necessary outcome of the very nature of things, of an inextricable factor; it cannot be removed by any ideology and produces its effects whether the laws and the administrators and judges are prepared to take notice of it or not. Thus in their eyes the Volkswirtschaft appears as a nature-given reality, while the world-embracing ecumenic society of men, the world economy (Weltwirtschaft), is only an imaginary phantom of a spurious doctrine, a plan devised for the destruction of civilization.

The truth is that individuals in their acting, in their capacity as producers and consumers, as sellers and buyers, do not make any distinction as between the domestic market and the foreign market. They make a distinction as between local trade and trading with more distant places as far as the costs of transportation play a role. If government interference, such as tariffs, renders international transactions more expensive, they take this fact into account in the same way in which they pay regard to shipping costs. A tariff on caviar has no effect other than would a rise in the cost of transportation. A rigid prohibition of the importation of caviar produces a state of affairs no different from that which would prevail if caviar could not stand shipping without an essential deterioration in its quality.

There has never been in the history of the West such a thing as regional or national autarky. There was, as we may admit, a period in which the division of labor did not go beyond the members of a family household. There was autarky of families and tribes which did not practice interpersonal exchange. But as soon as interpersonal exchange emerged, it crossed the boundaries of the political communities. Barter between the inhabitants of regions more remote from one another, between the members of various tribes, villages, and political communities preceded the practice of barter between neighbors. What people wanted first to acquire by barter and trade were things they could not produce themselves out of their own resources. Salt, other minerals and metals, the deposits of which are unequally distributed over the earth’s surface, cereals which one could not grow on the domestic soil, and artifacts which only the inhabitants of some regions were able to manufacture were the first objects of trade. Trade started as foreign trade. Only later did domestic exchange develop between neighbors. The first holes that opened the closed household economy to interpersonal exchange were made by the products of distant regions. No consumer cared on his own account whether the salt and the metals he bought were of “domestic” or of “foreign” provenance. If it had been otherwise, the governments Edition: current; Page: [326] would not have had any reason to interfere by means of tariffs and other barriers to foreign trade.

But even if a government succeeds in making the barriers separating its domestic market from foreign markets insurmountable and thus establishes perfect national autarky, it does not create a Volkswirtschaft. A market economy which is perfectly autarkic remains for all that a market economy; it forms a closed and isolated catallactic system. The fact that its citizens miss the advantages which they could derive from the international division of labor is simply a datum of their economic conditions. Only if such an isolated country goes outright socialist, does it convert its market economy into a Volkswirtschaft.

Fascinated by the propaganda of Neo-Mercantilism, people apply idioms which are in contrast to the principles they take as guides in their acting and to all the characteristics of the social order in which they are living. Long ago the British began to call plants and farms located in Great Britain, and even those located in the Dominions, in the East Indies, and in the colonies, “ours.” But if a man did not just want to make a show of his patriotic zeal and to impress other people, he was not prepared to pay a higher price for the products of his “own” plants than for those of the “foreign” plants. Even if he had behaved in this way, the designation of the plants located within the political boundaries of his nation as “ours” would not be adequate. In what sense could a Londoner, before the nationalization, call coal mines located in England which he did not own “our” mines and those of the Ruhr “foreign” mines? Whether he bought “British” coal or “German” coal, he always had to pay the full market price. It is not “America” that buys champagne from “France.” It is always an individual American who buys it from an individual Frenchman.

As far as there is still some room left for the actions of individuals, as far as there is private ownership and exchange of goods and services between individuals, there is no Volkswirtschaft. Only if full government control is substituted for the choices of individuals does the Volkswirtschaft emerge as a real entity.

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CHAPTER 16: Prices

1: The Pricing Process

In an occasional act of barter in which men who ordinarily do not resort to trading with other people exchange goods ordinarily not negotiated, the ratio of exchange is determined only within broad margins. Catallactics, the theory of exchange ratios and prices, cannot determine at what point within these margins the concrete ratio will be established. All that it can assert with regard to such exchanges is that they can be effected only if each party values what he receives more highly than what he gives away.

The recurrence of individual acts of exchange generates the market step by step with the evolution of the division of labor within a society based on private property. As it becomes a rule to produce for other people’s consumption, the members of society must sell and buy. The multiplication of the acts of exchange and the increase in the number of people offering or asking for the same commodities narrow the margins between the valuations of the parties. Indirect exchange and its perfection through the use of money divide the transactions into two different parts: sale and purchase. What in the eyes of one party is a sale, is for the other party a purchase. The divisibility of money, unlimited for all practical purposes, makes it possible to determine the exchange ratios with nicety. The exchange ratios are now as a rule money prices. They are determined between extremely narrow margins: the valuations on the one hand of the marginal buyer and those of the marginal offerer who abstains from selling, and the valuations on the other hand of the marginal seller and those of the marginal potential buyer who abstains from buying.

The concatenation of the market is an outcome of the activities of entrepreneurs, promoters, speculators, and dealers in futures and in arbitrage. It has been asserted that catallactics is based on the assumption—contrary to reality—that all parties are provided with perfect knowledge concerning the market data and are therefore in a position to take best advantage of the most favorable opportunities for Edition: current; Page: [328] buying and selling. It is true that some economists really believed that such an assumption is implied in the theory of prices. These authors not only failed to realize in what respects a world peopled with men perfectly equal in knowledge and foresight would differ from the real world which all economists wanted to interpret in developing their theories; they also erred in being unaware of the fact that they themselves did not resort to such an assumption in their own treatment of prices.

In an economic system in which every actor is in a position to recognize correctly the market situation with the same degree of insight, the adjustment of prices to every change in the data would be achieved at one stroke. It is impossible to imagine such uniformity in the correct cognition and appraisal of changes in data except by the intercession of superhuman agencies. We would have to assume that every man is approached by an angel informing him of the change in data which has occurred and advising him how to adjust his own conduct in the most adequate way to this change. Certainly the market that catallactics deals with is filled with people who are to different degrees aware of the changes in data and who, even if they have the same information, appraise it differently. The operation of the market reflects the fact that changes in the data are first perceived only by a few people and that different men draw different conclusions in appraising their effects. The more enterprising and brighter individuals take the lead, others follow later. The shrewder individuals appreciate conditions more correctly than the less intelligent and therefore succeed better in their actions. Economists must never disregard in their reasoning the fact that the innate and acquired inequality of men differentiates their adjustment to the conditions of their environment.

The driving force of the market process is provided neither by the consumers nor by the owners of the means of production—land, capital goods, and labor—but by the promoting and speculating entrepreneurs. These are people intent upon profiting by taking advantage of differences in prices. Quicker of apprehension and farther-sighted than other men, they look around for sources of profit. They buy where and when they deem prices too low, and they sell where and when they deem prices too high. They approach the owners of the factors of production, and their competition sends the prices of these factors up to the limit corresponding to their anticipation of the future prices of the products. They approach the consumers, and their competition forces prices of consumers’ goods down to the point at which the whole supply can be sold. Profit-seeking speculation Edition: current; Page: [329] is the driving force of the market as it is the driving force of production.

On the market agitation never stops. The imaginary construction of an evenly rotating economy has no counterpart in reality. There can never emerge a state of affairs in which the sum of the prices of the complementary factors of production, due allowance being made for time preference, equals the prices of the products and no further changes are to be expected. There are always profits to be earned by somebody. The speculators are always enticed by the expectation of profit.

The imaginary construction of the evenly rotating economy is a mental tool for comprehension of entrepreneurial profit and loss. It is, to be sure, not a design for comprehension of the pricing process. The final prices corresponding to this imaginary conception are by no means identical with the market prices. The activities of the entrepreneurs or of any other actors on the economic scene are not guided by consideration of any such things as equilibrium prices and the evenly rotating economy. The entrepreneurs take into account anticipated future prices, not final prices or equilibrium prices. They discover discrepancies between the height of the prices of the complementary factors of production and the anticipated future prices of the products, and they are intent upon taking advantage of such discrepancies. These endeavors of the entrepreneurs would finally result in the emergence of the evenly rotating economy if no further changes in the data were to appear.

The operation of the entrepreneurs brings about a tendency toward an equalization of prices for the same goods in all subdivisions of the market, due allowance being made for the cost of transportation and the time absorbed by it. Differences in prices which are not merely transitory and bound to be wiped out by entrepreneurial action are always the outcome of particular obstacles obstructing the inherent tendency toward equalization. Some check prevents profit-seeking business from interfering. An observer not sufficiently familiar with actual commercial conditions is often at a loss to recognize the institutional barrier hindering such equalization. But the merchants concerned always know what makes it impossible for them to take advantage of such differences.

Statisticians treat this problem too lightly. When they have discovered differences in the wholesale price of a commodity between two cities or countries, not entirely accounted for by the cost of transportation, tariffs, and excise duties, they acquiesce in asserting that the purchasing power of money and the “level” of prices are Edition: current; Page: [330] different.1 On the basis of such statements people draft programs to remove these differences by monetary measures. However, the root cause of these differences cannot lie in monetary conditions. If prices in both countries are quoted in terms of the same kind of money, it is necessary to answer the question as to what prevents businessmen from embarking upon dealings which are bound to make price differences disappear. Things are essentially the same if the prices are expressed in terms of different kinds of money. For the mutual exchange ratio between various kinds of money tends toward a point at which there is no further margin left to profitable exploitation of differences in commodity prices. Whenever differences in commodity prices between various places persist, it is a task for economic history and descriptive economics to establish what institutional barriers hinder the execution of transactions which must result in the equalization of prices.

All the prices we know are past prices. They are facts of economic history. In speaking of present prices we imply that the prices of the immediate future will not differ from those of the immediate past. However, all that is asserted with regard to future prices is merely an outcome of the understanding of future events.

The experience of economic history never tells us more than that at a definite date and definite place two parties A and B traded a definite quantity of the commodity a against a definite number of units of the money p. In speaking of such acts of buying and selling at the market price of a, we are guided by a theoretical insight, deduced from an aprioristic starting point. This is the insight that, in the absence of particular factors making for price differences, the prices paid at the same time and the same place for equal quantities of the same commodity tend toward equalization, viz., a final price. But the actual market prices never reach this final state. The various market prices about which we can get information were determined under different conditions. It is impermissible to confuse averages computed from them with the final prices.

Only with regard to fungible commodities negotiated on organized stock or commodity exchanges is it permissible, in comparing prices, to assume that they refer to the same quality. Apart from such prices negotiated in exchanges and from prices of commodities the homogeneity of which can be precisely established by technological analysis, Edition: current; Page: [331] it is a serious blunder to disregard differences in the quality of the commodity in question. Even in the wholesale trade of raw textiles the diversity of the articles plays the main role. A comparison of prices of consumers’ goods is mainly misleading on account of the difference in quality. The quantity traded in one transaction too is relevant in the determination of the price paid per unit. Shares of a corporation sold in one large lot bring a different price than those sold in several small lots.

It is necessary to emphasize these facts again and again because it is customary nowadays to play off the statistical elaboration of price data against the theory of prices. However, the statistics of prices is altogether questionable. Its foundations are precarious because circumstances for the most part do not permit the comparison of the various data, their linking together in series, and the computation of averages. Full of zeal to embark upon mathematical operations, the statisticians yield to the temptation of disregarding the incomparability of the data available. The information that a certain firm sold at a definite date a definite type of shoes for six dollars a pair relates a fact of economic history. A study of the behavior of shoe prices from 1923 to 1939 is conjectural, however sophisticated the methods applied may be.

Catallactics shows that entrepreneurial activities tend toward an abolition of price differences not caused by the costs of transportation and trade barriers. No experience has ever contradicted this theorem. The results obtained by an arbitrary identification of unequal things are irrelevant.

2: Valuation and Appraisement

The ultimate source of the determination of prices is the value judgments of the consumers. Prices are the outcome of the valuation preferring a to b. They are social phenomena as they are brought about by the interplay of the valuations of all individuals participating in the operation of the market. Each individual, in buying or not buying and in selling or not selling, contributes his share to the formation of the market prices. But the larger the market is, the smaller is the weight of each individual’s contribution. Thus the structure of market prices appears to the individual as a datum to which he must adjust his own conduct.

The valuations which result in determination of definite prices are different. Each party attaches a higher value to the good he receives than to that he gives away. The exchange ratio, the price, is not the product of an equality of valuation, but, on the contrary, the product of a discrepancy in valuation.

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Appraisement must be clearly distinguished from valuation. Appraisement in no way depends upon the subjective valuation of the man who appraises. He is not intent upon establishing the subjective use-value of the good concerned, but upon anticipating the prices which the market will determine. Valuation is a value judgment expressive of a difference in value. Appraisement is the anticipation of an expected fact. It aims at establishing what prices will be paid on the market for a particular commodity or what amount of money will be required for the purchase of a definite commodity.

Valuation and appraisement are, however, closely connected. The valuations of an autarkic husbandman directly compare the weight he attaches to different means for the removal of uneasiness. The valuations of a man buying and selling on the market must not disregard the structure of market prices; they depend upon appraisement. In order to know the meaning of a price one must know the purchasing power of the amount of money concerned. It is necessary by and large to be familiar with the prices of those goods which one would like to acquire and to form on the ground of such knowledge an opinion about their future prices. If an individual speaks of the costs incurred by the purchase of some goods already acquired or to be incurred by the purchase of goods he plans to acquire, he expresses these costs in terms of money. But this amount of money represents in his eyes the degree of satisfaction he could obtain by employing it for the acquisition of other goods. The valuation makes a detour, it goes via the appraisement of the structure of market prices; but it always aims finally at the comparison of alternative modes for the removal of felt uneasiness.

It is ultimately always the subjective value judgments of individuals that determine the formation of prices. Catallactics in conceiving the pricing process necessarily reverts to the fundamental category of action, the preference given to a over b. In view of popular errors it is expedient to emphasize that catallactics deals with the real prices as they are paid in definite transactions and not with imaginary prices. The concept of final prices is merely a mental tool for the grasp of a particular problem, the emergence of entrepreneurial profit and loss. The concept of a “just” or “fair” price is devoid of any scientific meaning; it is a disguise for wishes, a striving for a state of affairs different from reality. Market prices are entirely determined by the value judgments of men as they really act.

If one says that prices tend toward a point at which total demand is equal to total supply, one resorts to another mode of expressing the same concatenation of phenomena. Demand and supply are the outcome Edition: current; Page: [333] of the conduct of those buying and selling. If, other things being equal, supply increases, prices must drop. At the previous price all those ready to pay this price could buy the quantity they wanted to buy. If the supply increases, they must buy larger quantities or other people who did not buy before must become interested in buying. This can only be attained at a lower price.

It is possible to visualize this interaction by drawing two curves, the demand curve and the supply curve, whose intersection shows the price. It is no less possible to express it in mathematical symbols. But it is necessary to comprehend that such pictorial or mathematical modes of representation do not affect the essence of our interpretation and that they do not add a whit to our insight. Furthermore it is important to realize that we do not have any knowledge or experience concerning the shape of such curves. Always, what we know is only market prices—that is, not the curves but only a point which we interpret as the intersection of two hypothetical curves. The drawing of such curves may prove expedient in visualizing the problems for undergraduates. For the real tasks of catallactics they are mere byplay.

3: The Prices of the Goods of Higher Orders

The market process is coherent and indivisible. It is an indissoluble intertwinement of actions and reactions, of moves and countermoves. But the insufficiency of our mental abilities enjoins upon us the necessity of dividing it into parts and analyzing each of these parts separately. In resorting to such artificial cleavages we must never forget that the seemingly autonomous existence of these parts is an imaginary makeshift of our minds. They are only parts, that is, they cannot even be thought of as existing outside the structure of which they are parts.

The prices of the goods of higher orders are ultimately determined by the prices of the goods of the first or lowest order, that is, the consumers’ goods. As a consequence of this dependence they are ultimately determined by the subjective valuations of all members of the market society. It is, however, important to realize that we are faced with a connection of prices, not with a connection of valuations. The prices of the complementary factors of production are conditioned by the prices of the consumers’ goods. The factors of production are appraised with regard to the prices of the products, and from this appraisement their prices emerge. Not the valuations but the appraisements are transferred from the goods of the first order to those of higher orders. The prices of the consumers’ goods engender Edition: current; Page: [334] the actions resulting in the determination of the prices of the factors of production. These prices are primarily connected only with the prices of the consumers’ goods. With the valuations of the individuals they are only indirectly connected, viz., through the intermediary of the prices of the consumers’ goods, the products of their joint employment.

The tasks incumbent upon the theory of the prices of factors of production are to be solved by the same methods which are employed for treatment of the prices of consumers’ goods. We conceive the operation of the market of consumers’ goods in a twofold way. We think on the one hand of a state of affairs which leads to acts of exchange; the situation is such that the uneasiness of various individuals can be removed to some extent because various people value the same goods in a different way. On the other hand we think of a situation in which no further acts of exchange can happen because no actor expects any further improvement of his satisfaction by further acts of exchange. We proceed in the same way in comprehending the formation of the prices of factors of production. The operation of this market is actuated and kept in motion by the exertion of the promoting entrepreneurs, eager to profit from differences in the market prices of the factors of production and the expected prices of the products. The operation of this market would stop if a situation were ever to emerge in which the sum of the prices of the complementary factors of production—but for interest—equaled the prices of the products and nobody believed that further price changes were to be expected. Thus we have described the process adequately and completely by pointing out, positively, what actuates it and, negatively, what would suspend its motion. The main importance is to be attached to the positive description. The negative description resulting in the imaginary constructions of the final price and the evenly rotating economy is merely auxiliary. For the task is not the treatment of imaginary concepts, which never appear in life and action, but the treatment of the market prices at which the goods of higher orders are really bought and sold.

This method we owe to Gossen, Carl Menger, and Böhm-Bawerk. Its main merit is that it implies the cognition that we are faced with a phenomenon of price determination inextricably linked with the market process. It distinguishes between two things: (a) the direct valuation of the factors of production which attaches the value of the product to the total complex of the complementary factors of production, and (b) the prices of the single factors of production which are formed on the market as the resultant of the concurring Edition: current; Page: [335] actions of competing highest bidders. Valuation as it can be practiced by an isolated actor (Robinson Crusoe or a socialist board of production management) can never result in a determination of such a thing as quotas of value. Valuation can only arrange goods in scales of preference. It can never attach to a good something that could be called a quantity or magnitude of value. It would be absurd to speak of a sum of valuations or values. It is permissible to declare that, due allowance being made for time preference, the value attached to a product is equal to the value of the total complex of complementary factors of production. But it would be nonsensical to assert that the value attached to a product is equal to the “sum” of the values attached to the various complementary factors of production. One cannot add up values or valuations. One can add up prices expressed in terms of money, but not scales of preference. One cannot divide values or single out quotas of them. A value judgment never consists in anything other than preferring a to b.

The process of value imputation does not result in derivation of the value of the single productive agents from the value of their joint product. It does not bring about results which could serve as elements of economic calculation. It is only the market that, in establishing prices for each factor of production, creates the conditions required for economic calculation. Economic calculation always deals with prices, never with values.

The market determines prices of factors of production in the same way in which it determines prices of consumers’ goods. The market process is an interaction of men deliberately striving after the best possible removal of dissatisfaction. It is impossible to think away or to eliminate from the market process the men actuating its operation. One cannot deal with the market of consumers’ goods and disregard the actions of the consumers. One cannot deal with the market of the goods of higher orders while disregarding the actions of the entrepreneurs and the fact that the use of money is essential in their transactions. There is nothing automatic or mechanical in the operation of the market. The entrepreneurs, eager to earn profits, appear as bidders at an auction, as it were, in which the owners of the factors of production put up for sale land, capital goods, and labor. The entrepreneurs are eager to outdo one another by bidding higher prices than their rivals. Their offers are limited on the one hand by their anticipation of future prices of the products and on the other hand by the necessity to snatch the factors of production away from the hands of other entrepreneurs competing with them.

The entrepreneur is the agency that prevents the persistence of a Edition: current; Page: [336] state of production unsuitable to fill the most urgent wants of the consumers in the cheapest way. All people are anxious for the best possible satisfaction of their wants and are in this sense striving after the highest profit they can reap. The mentality of the promoters, speculators, and entrepreneurs is not different from that of their fellow men. They are merely superior to the masses in mental power and energy. They are the leaders on the way toward material progress. They are the first to understand that there is a discrepancy between what is done and what could be done. They guess what the consumers would like to have and are intent upon providing them with these things. In the pursuit of such plans they bid higher prices for some factors of production and lower the prices of other factors of production by restricting their demand for them. In supplying the market with those consumers’ goods in the sale of which the highest profits can be earned, they create a tendency toward a fall in their prices. In restricting the output of those consumers’ goods the production of which does not offer chances for reaping profit, they bring about a tendency toward a rise in their prices. All these transformations go on ceaselessly and could stop only if the unrealizable conditions of the evenly rotating economy and of static equilibrium were to be attained.

In drafting their plans the entrepreneurs look first at the prices of the immediate past which are mistakenly called present prices. Of course, the entrepreneurs never make these prices enter into their calculations without paying regard to anticipated changes. The prices of the immediate past are for them only the starting point of deliberations leading to forecasts of future prices. The prices of the past do not influence the determination of future prices. It is, on the contrary, the anticipation of future prices of the products that determines the state of prices of the complementary factors of production. The determination of prices has, as far as the mutual exchange ratios between various commodities are concerned,2 no direct causal relation whatever with the prices of the past. The allocation of the nonconvertible factors of production among the various branches of production3 and the amount of capital goods available for future production are historical magnitudes; in this regard the past is instrumental in shaping the course of future production and in affecting the prices of the future. But directly the prices of the factors of production are determined Edition: current; Page: [337] exclusively by the anticipation of future prices of the products. The fact that yesterday people valued and appraised commodities in a different way is irrelevant. The consumers do not care about the investments made with regard to past market conditions and do not bother about the vested interests of entrepreneurs, capitalists, landowners, and workers, who may be hurt by changes in the structure of prices. Such sentiments play no role in the formation of prices. (It is precisely the fact that the market does not respect vested interests that makes the people concerned ask for government interference.) The prices of the past are for the entrepreneur, the shaper of future production, merely a mental tool. The entrepreneurs do not construct afresh every day a radically new structure of prices or allocate anew the factors of production to the various branches of industry. They merely transform what the past has transmitted in better adapting it to the altered conditions. How much of the previous conditions they preserve and how much they change depends on the extent to which the data have changed.

The economic process is a continuous interplay of production and consumption. Today’s activities are linked with those of the past through the technological knowledge at hand, the amount and the quality of the capital goods available, and the distribution of the ownership of these goods among various individuals. They are linked with the future through the very essence of human action; action is always directed toward the improvement of future conditions. In order to see his way in the unknown and uncertain future man has within his reach only two aids: experience of past events and his faculty of understanding. Knowledge about past prices is a part of this experience and at the same time the starting point of understanding the future.

If the memory of all prices of the past were to fade away, the pricing process would become more troublesome, but not impossible as far as the mutual exchange ratios between various commodities are concerned. It would be harder for the entrepreneurs to adjust production to the demand of the public, but it could be done nonetheless. It would be necessary for them to assemble anew all the data they need as the basis of their operations. They would not avoid mistakes which they now evade on account of experience at their disposal. Price fluctuations would be more violent at the beginning, factors of production would be wasted, want-satisfaction would be impaired. But finally, having paid dearly, people would again have acquired the experience needed for a smooth working of the market process.

The essential fact is that it is the competition of profit-seeking entrepreneurs Edition: current; Page: [338] that does not tolerate the preservation of false prices of the factors of production. The activities of the entrepreneurs are the element that would bring about the unrealizable state of the evenly rotating economy if no further changes were to occur. In the world-embracing public sale called the market they are the bidders for the factors of production. In bidding, they are the mandataries of the consumers, as it were. Each entrepreneur represents a different aspect of the consumers’ wants, either a different commodity or another way of producing the same commodity. The competition among the entrepreneurs is ultimately a competition among the various possibilities open to men to remove their uneasiness as far as possible by the acquisition of consumers’ goods. The decisions of the consumers to buy one commodity and to postpone buying another determine the prices of factors of production required for manufacturing these commodities. The competition among the entrepreneurs reflects the prices of consumers’ goods in the formation of the prices of the factors of production. It reflects in the external world the conflict which the inexorable scarcity of the factors of production brings about in the soul of each individual. It makes effective the subsumed decisions of the consumers as to what purpose the nonspecific factors should be used for and to what extent the specific factors of production should be used.

The pricing process is a social process. It is consummated by an interaction of all members of the society. All collaborate and cooperate, each in the particular role he has chosen for himself in the framework of the division of labor. Competing in cooperation and cooperating in competition all people are instrumental in bringing about the result, viz., the price structure of the market, the allocation of the factors of production to the various lines of want-satisfaction, and the determination of the share of each individual. These three events are not three different matters. They are only different aspects of one indivisible phenomenon which our analytical scrutiny separates into three parts. In the market process they are accomplished uno actu [(Latin) by a single action]. Only people prepossessed by socialist leanings who cannot free themselves from longing glances at socialist methods speak of three different processes in dealing with the market phenomena: the determination of prices, the direction of productive efforts, and distribution.

A Limitation on the Pricing of Factors of Production

The process which makes the prices of the factors of production spring from the prices of products can achieve its results only if, of the complementary factors not replaceable by substitutes, not more Edition: current; Page: [339] than one is of absolutely specific character, that is, is not suitable for any other employment. If the production of a product requires two or more absolutely specific factors, only a cumulative price can be assigned to them. If all factors of production were absolutely specific, the pricing process would not achieve more than such cumulative prices. It would accomplish nothing more than statements like this: as combining 3 a and 5 b produces one unit of p, 3 a and 5 b together are equal to 1 p and the final price of 3 a 5 b is—due allowance being made for time preference—equal to the final price of 1 p. As entrepreneurs who want to use a and b for purposes other than the production of p do not bid for them, a more detailed price determination is impossible. Only if a demand emerges for a (or for b) on the part of entrepreneurs who want to employ a (or b) for other purposes, does competition between them and the entrepreneurs planning the production of p arise and a price for a (or for b) come into existence, the height of which determines also the price of b (or a).

A world in which all the factors of production are absolutely specific could manage its affairs with such cumulative prices. In such a world there would not exist the problem of how to allocate the means of production to various branches of want-satisfaction. In our real world things are different. There are many scarce means of production which can be employed for various tasks. There the economic problem is to employ these factors in such a way that no unit of them should be used for the satisfaction of a less urgent need if this employment prevents the satisfaction of a more urgent need. It is this that the market solves in determining the prices of the factors of production. The social service rendered by this solution is not in the least impaired by the fact that for factors which can be employed only cumulatively no other than cumulative prices are determined.

Factors of production which can be used in the same ratio of combination for the production of various commodities but do not allow of any other use, are to be considered as absolutely specific factors. They are absolutely specific with regard to the production of an intermediary product which can be utilized for various purposes. The price of this intermediary product can be assigned to them cumulatively only. Whether this intermediary product can be directly apperceived by the senses or whether it is merely the invisible and intangible outcome of their joint employment makes no difference.

4: Cost Accounting

In the calculation of the entrepreneur costs are the amount of money required for the procurement of the factors of production. The entrepreneur is intent upon embarking upon those business projects from which he expects the highest surplus of proceeds over costs and upon shunning projects from which he expects a lower Edition: current; Page: [340] amount of profit or even a loss. In doing this he adjusts his effort to the best possible satisfaction of the needs of the consumers. The fact that a project is not profitable because costs are higher than proceeds is the outcome of the fact that there is a more useful employment available for the factors of production required. There are other products in the purchase of which the consumers are prepared to allow for the prices of these factors of production. But the consumers are not prepared to pay these prices in buying the commodity the production of which is not profitable.

Cost accounting is affected by the fact that the two following conditions are not always present:

First, every increase in the quantity of factors expended for the production of a consumers’ good increases its power to remove uneasiness.

Second, every increase in the quantity of a consumers’ good requires a proportional increase in the expenditure of factors of production or even a more than proportional increase in their expenditure.

If both these conditions were always and without any exception fulfilled, every increment z expended for increasing the quantity m of a commodity g would be employed for the satisfaction of a need viewed as less urgent than the least urgent need already satisfied by the quantity m available previously. At the same time the increment z would require the employment of factors of production to be withdrawn from the satisfaction of other needs considered as more pressing than those needs whose satisfaction was foregone in order to produce the marginal unit of m. On the one hand the marginal value of the satisfaction derived from the increase in the quantity available of g would drop. On the other hand the costs required for the production of additional quantities of g would increase in marginal disutility; factors of production would be withheld from employments in which they could satisfy more urgent needs. Production must stop at the point at which the marginal utility of the increment no longer compensates for the marginal increase in the disutility of costs.

Now these two conditions are present very often, but not generally without exception. There exist many commodities of all orders of goods whose physical structure is not homogeneous and which are therefore not perfectly divisible.

It would, of course, be possible to conjure away the deviation from the first condition mentioned above by a sophisticated play on words. One could say: half a motorcar is not a motorcar. If one adds to half a motorcar a quarter of a motorcar, one does not increase the “quantity” Edition: current; Page: [341] available; only the perfection of the process of production which turns out a complete car produces a unit and an increase in the “quantity” available. However, such an interpretation misses the point. The problem we must face is that not every increase in expenditure increases proportionately the objective use-value, the physical power of a thing to render a definite service. The various increments in expenditure bring about different results. There are increments the expenditure of which remains useless if no further increments of a definite quantity are added.

On the other hand—and this is the deviation from the second condition—an increase in physical output does not always require a proportionate increase in expenditure or even any additional expenditure. It may happen that costs do not rise at all or that their rise increases output more than proportionately. For many means of production are not homogeneous either and not perfectly divisible. This is the phenomenon known to business as the superiority of big-scale production. The economists speak of the law of increasing returns or decreasing costs.

We consider—as case A—a state of affairs in which all factors of production are not perfectly divisible and in which full utilization of the productive services rendered by every further indivisible element of each factor requires full utilization of the further indivisible elements of every other of the complementary factors. Then in every aggregate of productive agents each of the assembled elements—every machine, every worker, every piece of raw material—can be fully utilized only if all the productive services of the other elements are fully employed too. Within these limits the production of a part of the maximum output attainable does not require a higher expenditure than the production of the highest possible output. We may also say that the minimum-size aggregate always produces the same quantity of products; it is impossible to produce a smaller quantity of products even if there is no use for a part of it.

We consider—as case B—a state of affairs in which one group of the productive agents (p) is for all practical purposes perfectly divisible. On the other hand the imperfectly divisible agents can be divided in such a way that full utilization of the services rendered by each further indivisible part of one agent requires full utilization of the further indivisible parts of the other imperfectly divisible complementary factors. Then increasing production of an aggregate of further indivisible factors from a partial to a more complete utilization of their productive capacity requires merely an increase in the quantity of p, the perfectly divisible factors. However, one must Edition: current; Page: [342] guard oneself against the fallacy that this necessarily implies a decrease in the average cost of production. It is true that within the aggregate of imperfectly divisible factors each of them is now better utilized, that therefore costs of production as far as they are caused by the cooperation of these factors remain unchanged, and that the quotas falling to a unit of output are decreasing. But on the other hand an increase in the employment of the perfectly divisible factors of production can be attained only by withdrawing them from other employments. The value of these other employments increases, other things being equal, with their shrinking; the price of these perfectly divisible factors tends to rise as more of them are used for the better utilization of the productive capacity of the aggregate of the not further divisible factors in question. One must not limit the consideration of our problem to the case in which the additional quantity of p is withdrawn from other enterprises producing the same product in a less efficient way and forces these enterprises to restrict their output. It is obvious that in this case—competition between a more and a less efficient enterprise producing the same article out of the same raw materials—the average cost of production is decreasing in the expanding plant. A more general scrutiny of the problem leads to a different result. If the units of p are withdrawn from other employments in which they would have been utilized for the production of other articles, there emerges a tendency toward an increase in the price of these units. This tendency may be compensated by accidental tendencies operating in the opposite direction; it may sometimes be so feeble that its effects are negligible. But it is always present and potentially influences the configuration of costs.

Finally we consider—as case C—a state of affairs in which various imperfectly divisible factors of production can be divided only in such a way that, given the conditions of the market, any size which can be chosen for their assemblage in a production aggregate does not allow for a combination in which full utilization of the productive capacity of one factor makes possible full utilization of the productive capacity of the other imperfectly divisible factors. This case C alone is of practical significance, while the cases A and B hardly play any role in real business. The characteristic feature of case C is that the configuration of production costs varies unevenly. If all imperfectly divisible factors are utilized to less than full capacity, an expansion of production results in a decrease of average costs of production unless a rise in the prices to be paid for the perfectly divisible factors counterbalances this outcome. But as soon as full utilization of the capacity of one of the imperfectly divisible factors is attained, further Edition: current; Page: [343] expansion of production causes a sudden sharp rise in costs. Then again a tendency toward a decrease in average production costs sets in and goes on working until full utilization of one of the imperfectly divisible factors is attained anew.

Other things being equal, the more production of a certain article increases, the more factors of production must be withdrawn from other employments in which they would have been used for the production of other articles. Hence—other things being equal—average production costs increase with the increase in the quantity produced. But this general law is by sections superseded by the phenomenon that not all factors of production are perfectly divisible and that, as far as they can be divided, they are not divisible in such a way that full utilization of one of them results in full utilization of the other imperfectly divisible factors.

The planning entrepreneur is always faced with the question: To what extent will the anticipated prices of the products exceed the anticipated costs? If the entrepreneur is still free with regard to the project in question, because he has not yet made any inconvertible investments for its realization, it is average costs that count for him. But if he has already a vested interest in the line of business concerned, he sees things from the angle of additional costs to be expended. He who already owns a not fully utilized production aggregate does not take into account average cost of production but marginal cost. Without regard to the amount already expended for inconvertible investments he is merely interested in the question whether or not the proceeds from the sale of an additional quantity of products will exceed the additional cost incurred by their production. Even if the whole amount invested in the inconvertible production facilities must be wiped off as a loss, he goes on producing provided he expects a reasonable4 surplus of proceeds over current costs.

With regard to popular errors it is necessary to emphasize that if the conditions required for the appearance of monopoly prices are not present, an entrepreneur is not in a position to increase his net returns by restricting production beyond the amount conforming with consumers’ demand. But this problem will be dealt with later in section 6.

That a factor of production is not perfectly divisible does not always mean that it can be constructed and employed in one size only. This, of course, may occur in some cases. But as a rule it is Edition: current; Page: [344] possible to vary the dimensions of these factors. If out of the various dimensions which are possible for such a factor—e.g., a machine—one dimension is distinguished by the fact that the costs incurred by its production and operation are rendered lower per unit of the productive services than those for other dimensions, things are essentially identical. Then the superiority of the bigger plant does not consist in the fact that it utilizes a machine to full capacity while the smaller plant utilizes only a part of the capacity of a machine of the same size. It consists rather in the fact that the bigger plant employs a machine which operates with a better utilization of the factors of production required for its construction and operation than does the smaller machine employed by the smaller plant.

The role played in all branches of production by the fact that many factors of production are not perfectly divisible is very great. It is of paramount importance in the course of industrial affairs. But one must guard oneself against many misinterpretations of its significance.

One of these errors was the doctrine according to which in the processing industries there prevails a law of increasing returns, while in agriculture and mining a law of decreasing returns prevails. The fallacies implied have been exploded above.5 As far as there is a difference in this regard between conditions in agriculture and those in the processing industries, differences in the data bring them about. The immobility of the soil and the fact that the performance of the various agricultural operations depends on the seasons make it impossible for farmers to take advantage of the capacity of many movable factors of production to the degree which conditions in manufacturing for the most part allow. The optimum size of a production outfit in agricultural production is as a rule much smaller than in the processing industries. It is obvious and does not need any further explanation why the concentration of farming cannot be pushed to anything near the degree obtaining in the processing industries.

However, the inequality in the distribution of natural resources over the earth’s surface, which is one of the two factors making for the higher productivity of the division of labor, puts a limit to the progress of concentration in the processing industries also. The tendency toward a progressive specialization and the concentration of integrated industrial processes in only a few plants is counteracted by the geographical dispersion of natural resources. The fact that the production of raw materials and foodstuffs cannot be centralized and forces people to disperse over the various part of the earth’s Edition: current; Page: [345] surface enjoins also upon the processing industries a certain degree of decentralization. It makes it necessary to consider the problems of transportation as a particular factor of production costs. The costs of transportation must be weighed against the economies to be expected from more thoroughgoing specialization. While in some branches of the processing industries the utmost concentration is the most adequate method of reducing costs, in other branches a certain degree of decentralization is more advantageous. In the servicing trades the disadvantages of concentration become so great that they almost entirely overweigh the advantages derived.

Then a historical factor comes into play. In the past capital goods were immobilized on sites on which our contemporaries would not have set them. It is immaterial whether or not this immobilization was the most economical procedure to which the generations that brought it about could resort. In any event the present generation is faced with a fait accompli [(French) accomplished fact, thing already done]. It must adjust its operations to the fact and it must take it into account in dealing with problems of the location of the processing industries.6

Finally there are institutional factors. There are trade and migration barriers. There are differences in political organization and methods of government between various countries. Vast areas are administered in such a way that it is practically out of the question to choose them as a seat for any capital investment no matter how favorable their physical conditions may be.

Entrepreneurial cost accounting must deal with all these geographical, historical and institutional factors. But even apart from them there are purely technical factors limiting the optimum size of plants and firms. The greater plant or firm may require provisions and procedures which the smaller plant or firm can avoid. In many instances the outlays caused by such provisions and procedures may be overcompensated by the reduction in costs derived from better utilization of the capacity of some of the not perfectly divisible factors employed. In other instances this may not be the case.

Under capitalism the arithmetical operations required for cost accounting and the confrontation of costs and proceeds can easily be effected as there are methods of economic calculation available. However, cost accounting and calculation of the economic significance of business projects under consideration is not merely a mathematical problem which can be solved satisfactorily by all those familiar with Edition: current; Page: [346] the elementary rules of arithmetic. The main question is the determination of the money equivalents of the items which are to enter into the calculation. It is a mistake to assume, as many economists do, that these equivalents are given magnitudes, uniquely determined by the state of economic conditions. They are speculative anticipations of uncertain future conditions and as such depend on the entrepreneur’s understanding of the future state of the market. The term fixed costs is also in this regard somewhat misleading.

Every action aims at the best possible supplying of future needs. To achieve these ends it must make the best possible use of the available factors of production. However, the historical process which brought about the present state of factors available is beside the point. What counts and influences the decisions concerning future action is solely the outcome of this historical process, the quantity and the quality of the factors available today. These factors are appraised only with regard to their ability to render productive services for the removal of future uneasiness. The amount of money spent in the past for their production and acquisition is immaterial.

It has already been pointed out that an entrepreneur who by the time he has to make a new decision has expended money for the realization of a definite project is in a different position from that of a man who starts afresh. The former owns a complex of inconvertible factors of production which he can employ for certain purposes. His decisions concerning further action will be influenced by this fact. But he appraises this complex not according to what he expended in the past for its acquisition. He appraises it exclusively from the point of view of its usefulness for future action. The fact that he has spent more or less for its acquisition is insignificant. This fact is only a factor in determining the amount of the entrepreneur’s past losses or profits and the present state of his fortune. It is an element in the historical process that brought about the present state of the supply of factors of production and as such it is of importance for future action. But it does not count for the planning of future action and the calculation regarding such action. It is irrelevant that the entries in the firm’s books differ from the actual price of such inconvertible factors of production.

Of course, such consummated losses or profits may motivate a firm to operate in a different way from which it would if it were not affected by them. Past losses may render a firm’s financial position precarious, especially if they bring about indebtedness and burden it with payments of interest and installments on the principal. However, it is not correct to refer to such payments as a part of fixed Edition: current; Page: [347] costs. They have no relation whatever to the current operations. They are not caused by the process of production, but by the methods employed by the entrepreneur in the past for the procurement of the capital and capital goods needed. They are only accidental with reference to the going concern. But they may enforce upon the firm in question a conduct of affairs which it would not adopt if it were financially stronger. The urgent need for cash in order to meet payments due does not affect its cost accounting, but its appraisal of ready cash as compared with cash that can only be received at a later day. It may impel the firm to sell inventories at an inappropriate moment and to use its durable production equipment in a way that unduly neglects its conservation for later use.

It is immaterial for the problems of cost accounting whether a firm owns the capital invested in its enterprise or whether it has borrowed a greater or smaller part of it and is bound to comply with the terms of a loan contract rigidly fixing the rate of interest and the dates of maturity for interest and principal. The costs of production include only the interest on the capital which is still existent and working in the enterprise. It does not include interest on capital squandered in the past by bad investment or by inefficiency in the conduct of current business operations. The task incumbent upon the businessman is always to use the supply of capital goods now available in the best possible way for the satisfaction of future needs. In the pursuit of this aim he must not be misled by past errors and failures the consequences of which cannot be brushed away. A plant may have been constructed in the past which would not have been built if one had better forecast the present situation. It is vain to lament this historical fact. The main thing is to find out whether or not the plant can still render any service and, if this question is answered in the affirmative, how it can be best utilized. It is certainly sad for the individual entrepreneur that he did not avoid errors. The losses incurred impair his financial situation. They do not affect the costs to be taken into account in planning further action.

It is important to stress this point because it has been distorted in the current interpretation and justification of various measures. One does not “reduce costs” by alleviating some firms’ and corporations’ burden of debts. A policy of wiping out debts or the interest due on them totally or in part does not reduce costs. It transfers wealth from creditors to debtors; it shifts the incidence of losses incurred in the past from one group of people to another group, e.g., from the owners of common stock to those of preferred stock and corporate bonds. This argument of cost reduction is often advanced in Edition: current; Page: [348] favor of currency devaluation. It is no less fallacious in this case than all the other arguments brought forward for this purpose.

What are commonly called fixed costs are also costs incurred by the exploitation of the already available factors of production which are either rigidly inconvertible or can be adapted for other productive purposes only at a considerable loss. These factors are of a more durable character than the other factors of production required. But they are not permanent. They are used up in the process of production. With each unit of product turned out a part of the machine’s power to produce is exhausted. The extent of this attrition can be precisely ascertained by technology and can be appraised accordingly in terms of money.

However, it is not only this money equivalent of the machine’s wearing out which the entrepreneurial calculation has to consider. The businessman is not merely concerned with the duration of the machine’s technological life. He must take into account the future state of the market. Although a machine may still be technologically perfectly utilizable, market conditions may render it obsolete and worthless. If the demand for its products drops considerably or disappears altogether or if more efficient methods for supplying the consumers with these products appear, the machine is economically merely scrap iron. In planning the conduct of his business the entrepreneur must pay full regard to the anticipated future state of the market. The amount of “fixed” costs which enter into his calculation depends on his understanding of future events. It is not to be fixed simply by technological reasoning.

The technologist may determine the optimum for a production aggregate’s utilization. But this technological optimum may differ from that which the entrepreneur on the ground of his judgment concerning future market conditions enters into his economic calculation. Let us assume that a factory is equipped with machines which can be utilized for a period of ten years. Every year 10 per cent of their prime costs is laid aside for depreciation. In the third year market conditions place a dilemma before the entrepreneur. He can double his output for the year and sell it at a price which (apart from covering the increase in variable costs) exceeds the quota of depreciation for the current year and the present value of the last depreciation quota. But this doubling of production trebles the wearing out of the equipment and the surplus proceeds from the sale of the double quantity of products are not great enough to make good also for the present value of the depreciation quota of the ninth year. If the entrepreneur were to consider the annual depreciation quota as a rigid Edition: current; Page: [349] element for his calculation, he would have to deem the doubling of production as not profitable, as additional proceeds lag behind additional cost. He would abstain from expanding production beyond the technological optimum. But the entrepreneur calculates in a different way, although in his accountancy he may lay aside the same quota for depreciation every year. Whether or not the entrepreneur prefers a fraction of the present value of the ninth year’s depreciation quota to the technological services which the machines could render him in the ninth year, depends on his opinion concerning the future state of the market.

Public opinion, governments and legislators, and the tax laws look upon a business outfit as a source of permanent revenue. They believe that the entrepreneur who makes due allowance for capital maintenance by annual depreciation quotas will always be in a position to reap a reasonable return from the capital invested in his durable producers’ goods. Real conditions are different. A production aggregate such as a plant and its equipment is a factor of production whose usefulness depends on changing market conditions and the skill of the entrepreneur in employing it in accordance with the change in conditions.

There is in the field of economic calculation nothing that is certain in the sense in which this term is used with regard to technological facts. The essential elements of economic calculation are speculative anticipations of future conditions. Commercial usages and customs and commercial laws have established definite rules for accountancy and auditing. There is accuracy in the keeping of books. But they are accurate only with regard to these rules. The book values do not reflect precisely the real state of affairs. The market value of an aggregate of durable producers’ goods may differ from the nominal figures the books show. The proof is that the Stock Exchange appraises them without any regard to these figures.

Cost accounting is therefore not an arithmetical process which can be established and examined by an indifferent umpire. It does not operate with uniquely determined magnitudes which can be found out in an objective way. Its essential items are the result of an understanding of future conditions, necessarily always colored by the entrepreneur’s opinion about the future state of the market.

Attempts to establish cost accounts on an “impartial” basis are doomed to failure. Calculating costs is a mental tool of action, the purposive design to make the best of the available means for an improvement of future conditions. It is necessarily volitional, not factual. In the hands of an indifferent umpire it changes its character Edition: current; Page: [350] entirely. The umpire does not look forward to the future. He looks backward to the dead past and to rigid rules which are useless for real life and action. He does not anticipate changes. He is unwittingly guided by the prepossession that the evenly rotating economy is the normal and most desirable state of human affairs. Profits do not fit into his scheme. He has a confused idea about a “fair” rate of profit or a “fair” return on capital invested. However, there are no such things. In the evenly rotating economy there are no profits. In a changing economy profits are not determined with reference to any set of rules by which they could be classified as fair or unfair. Profits are never normal. Where there is normality, i.e., absence of change, no profits can emerge.

5: Logical Catallactics Versus Mathematical Catallactics

The problems of prices and costs have been treated also with mathematical methods. There have even been economists who held that the only appropriate method of dealing with economic problems is the mathematical method and who derided the logical economists as “literary” economists.

If this antagonism between the logical and the mathematical economists were merely a disagreement concerning the most adequate procedure to be applied in the study of economics, it would be superfluous to pay attention to it. The better method would prove its preeminence by bringing about better results. It may also be that different varieties of procedure are necessary for the solution of different problems and that for some of them one method is more useful than the other.

However, this is not a dispute about heuristic questions, but a controversy concerning the foundations of economics. The mathematical method must be rejected not only on account of its barrenness. It is an entirely vicious method, starting from false assumptions and leading to fallacious inferences. Its syllogisms are not only sterile; they divert the mind from the study of the real problems and distort the relations between the various phenomena.

The ideas and procedures of the mathematical economists are not uniform. There are three main currents of thought which must be dealt with separately.

The first variety is represented by the statisticians who aim at discovering economic laws from the study of economic experience. They aim to transform economics into a “quantitative” science. Their program is condensed in the motto of the Econometric Society: Science is measurement.

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The fundamental error implied in this reasoning has been shown above.7 Experience of economic history is always experience of complex phenomena. It can never convey knowledge of the kind the experimenter abstracts from a laboratory experiment. Statistics is a method for the presentation of historical facts concerning prices and other relevant data of human action. It is not economics and cannot produce economic theorems and theories. The statistics of prices is economic history. The insight that, ceteris paribus, an increase in demand must result in an increase in prices is not derived from experience. Nobody ever was or ever will be in a position to observe a change in one of the market data ceteris paribus. There is no such thing as quantitative economics. All economic quantities we know about are data of economic history. No reasonable man can contend that the relation between price and supply is in general, or in respect of certain commodities, constant. We know, on the contrary, that external phenomena affect different people in different ways, that the reactions of the same people to the same external events vary, and that it is not possible to assign individuals to classes of men reacting in the same way. This insight is a product of our aprioristic theory. It is true the empiricists reject this theory; they pretend that they aim to learn only from historical experience. However, they contradict their own principles as soon as they pass beyond the unadulterated recording of individual single prices and begin to construct series and to compute averages. A datum of experience and a statistical fact is only a price paid at a definite time and a definite place for a definite quantity of a certain commodity. The arrangement of various price data in groups and the computation of averages are guided by theoretical deliberations which are logically and temporally antecedent. The extent to which certain attending features and circumstantial contingencies of the price data concerned are taken or not taken into consideration depends on theoretical reasoning of the same kind. Nobody is so bold as to maintain that a rise of a per cent in the supply of any commodity must always—in every country and at any time—result in a fall of b per cent in its price. But as no quantitative economist ever ventured to define precisely on the ground of statistical experience the special conditions producing a definite deviation from the ratio a:b, the futility of his endeavors is manifest. Moreover, money is not a standard for the measurement of prices; it is a medium whose exchange ratio varies in the same way, although as a rule not with the same speed and to Edition: current; Page: [352] the same extent, in which the mutual exchange ratios of the vendible commodities and services vary.

There is hardly any need to dwell longer upon the exposure of the claims of quantitative economics. In spite of all the high-sounding pronouncements of its advocates, nothing has been done for the realization of its program. The late Henry Schultz devoted his research to the measurement of elasticities of demand for various commodities. Professor Paul H. Douglas has praised the outcome of Schultz’s studies as “a work as necessary to help make economics a more or less exact science as was the determination of atomic weights for the development of chemistry.”8 The truth is that Schultz never embarked upon a determination of the elasticity of demand for any commodity as such; the data he relied upon were limited to certain geographical areas and historical periods. His results for a definite commodity, for instance potatoes, do not refer to potatoes in general, but to potatoes in the United States in the years from 1875 to 1929.9 They are, at best, rather questionable and unsatisfactory contributions to various chapters of economic history. They are certainly not steps toward the realization of the confused and contradictory program of quantitative economics. It must be emphasized that the two other varieties of mathematical economics are fully aware of the futility of quantitative economics. For they have never ventured to make any magnitudes as found by the econometricians enter into their formulas and equations and thus to adapt them for the solution of particular problems. There is in the field of human action no means for dealing with future events other than that provided by understanding.

The second field treated by mathematical economists is that of the relation of prices and costs. In dealing with these problems the mathematical economists disregard the operation of the market process and moreover pretend to abstract from the use of money inherent in all economic calculations. However, as they speak of prices and costs in general and confront prices and costs, they tacitly imply the existence and the use of money. Prices are always money prices, and costs cannot be taken into account in economic calculation if not expressed in terms of money. If one does not resort to terms of money, costs are expressed in complex quantities of diverse goods and services to be expended for the procurement of a product. On the other hand prices—if this term is applicable at all to exchange ratios determined by barter—are the enumeration of quantities of various goods against which the “seller” can exchange a definite supply. The goods Edition: current; Page: [353] which are referred to in such “prices” are not the same to which the “costs” refer. A comparison of such prices in kind and costs in kind is not feasible. That the seller values the goods he gives away less than those he receives in exchange for them, that the seller and the buyer disagree with regard to the subjective valuation of the two goods exchanged, and that an entrepreneur embarks upon a project only if he expects to receive for the product goods that he values higher than those expended in their production, all this we know already on the ground of praxeological comprehension. It is this aprioristic knowledge that enables us to anticipate the conduct of an entrepreneur who is in a position to resort to economic calculation. But the mathematical economist deludes himself when he pretends to treat these problems in a more general way by omitting any reference to terms of money. It is vain to investigate instances of nonperfect divisibility of factors of production without reference to economic calculation in terms of money. Such a scrutiny can never go beyond the knowledge already available; namely that every entrepreneur is intent upon producing those articles the sale of which will bring him proceeds that he values higher than the total complex of goods expended in their production. But if there is no indirect exchange and if no medium of exchange is in common use, he can succeed, provided he has correctly anticipated the future state of the market, only if he is endowed with a superhuman intellect. He would have to take in at a glance all exchange ratios determined at the market in such a way as to assign in his deliberations precisely the place due to every good according to these ratios.

It cannot be denied that all investigations concerning the relation of prices and costs presuppose both the use of money and the market process. But the mathematical economists shut their eyes to this obvious fact. They formulate equations and draw curves which are supposed to describe reality. In fact they describe only a hypothetical and unrealizable state of affairs, in no way similar to the catallactic problems in question. They substitute algebraic symbols for the determinate terms of money as used in economic calculation and believe that this procedure renders their reasoning more scientific. They strongly impress the gullible layman. In fact they only confuse and muddle things which are satisfactorily dealt with in textbooks of commercial arithmetic and accountancy.

Some of these mathematicians have gone so far as to declare that economic calculation could be established on the basis of units of utility. They call their methods utility analysis. Their error is shared by the third variety of mathematical economics.

The characteristic mark of this third group is that they are openly Edition: current; Page: [354] and consciously intent upon solving catallactic problems without any reference to the market process. Their ideal is to construct an economic theory according to the pattern of mechanics. They again and again resort to analogies with classical mechanics which in their opinion is the unique and absolute model of scientific inquiry. There is no need to explain again why this analogy is superficial and misleading and in what respects purposive human action radically differs from motion, the subject matter of mechanics. It is enough to stress one point, viz., the practical significance of the differential equations in both fields.

The deliberations which result in the formulation of an equation are necessarily of a nonmathematical character. The formulation of the equation is the consummation of our knowledge; it does not directly enlarge our knowledge. Yet, in mechanics the equation can render very important practical services. As there exist constant relations between various mechanical elements and as these relations can be ascertained by experiments, it becomes possible to use equations for the solution of definite technological problems. Our modern industrial civilization is mainly an accomplishment of this utilization of the differential equations of physics. No such constant relations exist, however, between economic elements. The equations formulated by mathematical economics remain a useless piece of mental gymnastics and would remain so even if they were to express much more than they really do.

A sound economic deliberation must never forget these two fundamental principles of the theory of value: First, valuing that results in action always means preferring and setting aside; it never means equivalence or indifference. Second, there is no means of comparing the valuations of different individuals or the valuations of the same individuals at different instants other than by establishing whether or not they arrange the alternatives in question in the same order of preference.

In the imaginary construction of the evenly rotating economy all factors of production are employed in such a way that each of them renders the most valuable service. No thinkable and possible change could improve the state of satisfaction; no factor is employed for the satisfaction of a need a if this employment prevents the satisfaction of a need b that is considered more valuable than the satisfaction of a. It is, of course, possible to describe this imaginary state of the allocation of resources in differential equations and to visualize it graphically in curves. But such devices do not assert anything about the market process. They merely mark out an imaginary situation in Edition: current; Page: [355] which the market process would cease to operate. The mathematical economists disregard the whole theoretical elucidation of the market process and evasively amuse themselves with an auxiliary notion employed in its context and devoid of any sense when used outside of this context.

In physics we are faced with changes occurring in various sense phenomena. We discover a regularity in the sequence of these changes and these observations lead us to the construction of a science of physics. We know nothing about the ultimate forces actuating these changes. They are for the searching mind ultimately given and defy any further analysis. What we know from observation is the regular concatenation of various observable entities and attributes. It is this mutual interdependence of data that the physicist describes in differential equations.

In praxeology the first fact we know is that men are purposively intent upon bringing about some changes. It is this knowledge that integrates the subject matter of praxeology and differentiates it from the subject matter of the natural sciences. We know the forces behind the changes, and this aprioristic knowledge leads us to a cognition of the praxeological processes. The physicist does not know what electricity “is.” He knows only phenomena attributed to something called electricity. But the economist knows what actuates the market process. It is only thanks to this knowledge that he is in a position to distinguish market phenomena from other phenomena and to describe the market process.

Now, the mathematical economist does not contribute anything to the elucidation of the market process. He merely describes an auxiliary makeshift employed by the logical economists as a limiting notion, the definition of a state of affairs in which there is no longer any action and the market process has come to a standstill. That is all he can say. What the logical economist sets forth in words when defining the imaginary constructions of the final state of rest and the evenly rotating economy and what the mathematical economist himself must describe in words before he embarks upon his mathematical work, is translated into algebraic symbols. A superficial analogy is spun out too long, that is all.

Both the logical and the mathematical economists assert that human action ultimately aims at the establishment of such a state of equilibrium and would reach it if all further changes in data were to cease. But the logical economist knows much more than that. He shows how the activities of enterprising men, the promoters and speculators, eager to profit from discrepancies in the price structure, tend toward Edition: current; Page: [356] eradicating such discrepancies and thereby also toward blotting out the sources of entrepreneurial profit and loss. He shows how this process would finally result in the establishment of the evenly rotating economy. This is the task of economic theory. The mathematical description of various states of equilibrium is mere play. The problem is the analysis of the market process.

A comparison of both methods of economic analysis makes us understand the meaning of the often raised request to enlarge the scope of economic science by the construction of a dynamic theory instead of the mere occupation with static problems. With regard to logical economics this postulate is devoid of any sense. Logical economics is essentially a theory of processes and changes. It resorts to the imaginary constructions of changelessness merely for the elucidation of the phenomena of change. But it is different with mathematical economics. Its equations and formulas are limited to the description of states of equilibrium and nonacting. It cannot assert anything with regard to the formation of such states and their transformation into other states as long as it remains in the realm of mathematical procedures. As against mathematical economics the request for a dynamic theory is well substantiated. But there is no means for mathematical economics to comply with this request. The problems of process analysis, i.e., the only economic problems that matter, defy any mathematical approach. The introduction of time parameters into the equations is no solution. It does not even indicate the essential shortcomings of the mathematical method. The statements that every change involves time and that change is always in the temporal sequence are merely a way of expressing the fact that as far as there is rigidity and unchangeability there is no time. The main deficiency of mathematical economics is not the fact that it ignores the temporal sequence, but that it ignores the operation of the market process.

The mathematical method is at a loss to show how from a state of non-equilibrium those actions spring up which tend toward the establishment of equilibrium. It is, of course, possible to indicate the mathematical operations required for the transformation of the mathematical description of a definite state of nonequilibrium into the mathematical description of the state of equilibrium. But these mathematical operations by no means describe the market process actuated by the discrepancies in the price structure. The differential equations of mechanics are supposed to describe precisely the motions concerned at any instant of the time traveled through. The economic equations have no reference whatever to conditions as they really are in each instant of the time interval between the state of nonequilibrium Edition: current; Page: [357] and that of equilibrium. Only those entirely blinded by the prepossession that economics must be a pale replica of mechanics will underrate the weight of this objection. A very imperfect and superficial metaphor is not a substitute for the services rendered by logical economics.

In every chapter of catallactics the devastating consequences of the mathematical treatment of economics can be tested. It is enough to refer to two instances only. One is provided by the so-called equation of exchange, the mathematical economists’ futile and misleading attempt to deal with changes in the purchasing power of money.10 The second can be best expressed in referring to Professor Schumpeter’s dictum according to which consumers in evaluating consumers’ goods “ipso facto [(Latin) by that very fact] also evaluate the means of production which enter into the production of these goods.”11 It is hardly possible to construe the market process in a more erroneous way.

Economics is not about goods and services, it is about the actions of living men. Its goal is not to dwell upon imaginary constructions such as equilibrium. These constructions are only tools of reasoning. The sole task of economics is analysis of the actions of men, is the analysis of processes.

6: Monopoly Prices

Competitive prices are the outcome of a complete adjustment of the sellers to the demand of the consumers. Under the competitive price the whole supply available is sold, and the specific factors of production are employed to the extent permitted by the prices of the nonspecific complementary factors. No part of a supply available is permanently withheld from the market, and the marginal unit of specific factors of production employed does not yield any net proceed. The whole economic process is conducted for the benefit of the consumers. There is no conflict between the interests of the buyers and those of the sellers, between the interests of the producers and those of the consumers. The owners of the various commodities are not in a position to divert consumption and production from the lines enjoined by the valuations of the consumers, the state of supply of goods and services of all orders and the state of technological knowledge.

Every single seller would see his own proceeds increased if a fall Edition: current; Page: [358] in the supply at the disposal of his competitors were to increase the price at which he himself could sell his own supply. But on a competitive market he is not in a position to bring about this outcome. Except for a privilege derived from government interference with business he must submit to the state of the market as it is.

The entrepreneur in his entrepreneurial capacity is always subject to the full supremacy of the consumers. It is different with the owners of vendible goods and factors of production and, of course, with the entrepreneurs in their capacity as owners of such goods and factors. Under certain conditions they fare better by restricting supply and selling it at a higher price per unit. The prices thus determined, the monopoly prices, are an infringement of the supremacy of the consumers and the democracy of the market.

The special conditions and circumstances required for the emergence of monopoly prices and their catallactic features are:

1. There must prevail a monopoly of supply. The whole supply of the monopolized commodity is controlled by a single seller or a group of sellers acting in concert. The monopolist—whether one individual or a group of individuals—is in a position to restrict the supply offered for sale or employed for production in order to raise the price per unit sold and need not fear that his plan will be frustrated by interference on the part of other sellers of the same commodity.

2. Either the monopolist is not in a position to discriminate among the buyers or he voluntarily abstains from such discrimination.12

3.

The reaction of the buying public to the rise in prices beyond the potential competitive price, the fall in demand, is not such as to render the proceeds resulting from total sales at any price exceeding the competitive price smaller than total proceeds resulting from total sales at the competitive price. Hence it is superfluous to enter into sophisticated disquisitions concerning what must be considered the mark of the sameness of an article. It is not necessary to raise the question whether all neckties are to be called specimens of the same article or whether one should distinguish them with regard to fabric, color, and pattern. An academic delimitation of various articles is useless. The only point that counts is the way in which the buyers react to the rise in prices. For the theory of monopoly prices it is irrelevant to observe that every necktie manufacturer turns out different articles and to call each of them a monopolist. Catallactics does not deal with monopoly as such but with monopoly prices. A seller of neckties which are different from those offered for sale by other Edition: current; Page: [359] people could attain monopoly prices only if the buyers did not react to any rise in prices in such a way as to make such a rise disadvantageous for him.

Monopoly is a prerequisite for the emergence of monopoly prices but it is not the only prerequisite. There is a further condition required, namely a certain shape of the demand curve. The mere existence of monopoly does not mean anything in this regard. The publisher of a copyright book is a monopolist. But he may not be able to sell a single copy, no matter how low the price he asks. Not every price at which a monopolist sells a monopolized commodity is a monopoly price. Monopoly prices are only prices at which it is more advantageous for the monopolist to restrict the total amount to be sold than to expand his sales to the limit which a competitive market would allow. They are the outcome of a deliberate design tending toward a restriction of trade.

4.

It is a fundamental mistake to assume that there is a third category of prices which are neither monopoly prices nor competitive prices. If we disregard the problem of price discrimination to be dealt with later, a definite price is either a competitive price or a monopoly price. The assertions to the contrary are due to the erroneous belief that competition is not free or perfect unless everybody is in a position to present himself as a seller of a definite commodity.

The available supply of every commodity is limited. If it were not scarce with regard to the demand of the public, the thing in question would not be considered an economic good, and no price would be paid for it. It is therefore misleading to apply the concept of monopoly in such a way as to make it cover the entire field of economic goods. Mere limitation of supply is the source of economic value and of all prices paid; as such it is not yet sufficient to generate monopoly prices.13

The term monopolistic or imperfect competition is applied today to cases in which there are some differences in the products of different producers and sellers. This means that almost all consumers’ goods are included in the class of monopolized goods. However, the only question relevant in the study of the determination of prices is whether these differences can be used by the seller for a scheme of deliberate restriction of supply for the sake of increasing his total net proceeds. Only if this is possible and put into effect, can monopoly prices emerge as differentiated from competitive prices. It may be true that every seller has a clientele which prefers his brand to those Edition: current; Page: [360] of his competitors and would not stop buying it even if the price were higher. But the problem for the seller is whether the number of such people is great enough to overcompensate the reduction of total sales which the abstention from buying on the part of other people would bring about. Only if this is the case, can he consider the substitution of monopoly prices for competitive prices advantageous.

Considerable confusion stems from a misinterpretation of the term control of supply. Every producer of every product has his share in controlling the supply of the commodities offered for sale. If he had produced more a, he would have increased supply and brought about a tendency toward a lower price. But the question is why he did not produce more of a. Was he in restricting his production of a to the amount of p intent upon complying to the best of his abilities with the wishes of the consumers? Or was he intent upon defying the orders of the consumers for his own advantage? In the first case he did not produce more of a, because increasing the quantity of a beyond p would have withdrawn scarce factors of production from other branches in which they would have been employed for the satisfaction of more urgent needs of the consumers. He does not produce p + r, but merely p, because such an increase would have rendered his business unprofitable or less profitable, while there are still other more profitable employments available for capital investment. In the second case he did not produce r, because it was more advantageous for him to leave a part of the available supply of a monopolized specific factor of production m unused. If m were not monopolized by him, it would have been impossible for him to expect any advantage from restricting his production of a. His competitors would have filled the gap and he would not have been in a position to ask higher prices.

In dealing with monopoly prices we must always search for the monopolized factor m. If no such factor is in the case, no monopoly prices can emerge. The first requirement for monopoly prices is the existence of a monopolized good. If no quantity of such a good m is withheld, there is no opportunity for an entrepreneur to substitute monopoly prices for competitive prices.

Entrepreneurial profit has nothing at all to do with monopoly. If an entrepreneur is in a position to sell at monopoly prices, he owes this advantage to his monopoly with regard to a monopolized factor m. He earns the specific monopoly gain from his ownership of m, not from his specific entrepreneurial activities.

Let us assume that an accident cuts a city’s electrical supply for several days and forces the residents to resort to candlelight only. Edition: current; Page: [361] The price of candles rises to s; at this price the whole supply available is sold out. The stores selling candles reap a high profit in selling their whole supply at s. But it could happen that the storekeepers combine in order to withhold a part of their stock from the market and to sell the rest at a price s + t. While s would have been the competitive price, s + t is a monopoly price. The surplus earned by the storekeepers at the price s + t over the proceeds they would have earned when selling at s only is their specific monopoly gain.

It is immaterial in what way the storekeepers bring about the restriction of the supply offered for sale. The physical destruction of a part of the supply available is the classical case of monopolistic action. Only a short time ago it was practiced by the Brazilian government in burning large quantities of coffee. But the same effect can be attained by leaving a part of the supply unused.

While profits are incompatible with the imaginary construction of the evenly rotating economy, monopoly prices and specific monopoly gains are not.

5.

If the available quantities of the good m are owned not by just one man, firm, corporation, or institution but by several owners who want to cooperate in the substitution of a monopoly price for the competitive price, an agreement among them (commonly called a cartel and branded in the American antitrust legislation as a conspiracy) is required to assign to each party the amount of m it is allowed to sell, viz., at the monopoly price. The essential part of any cartel agreement is the assignment of definite quotas to the partners. The art of cartel-making consists in skill in bringing about an agreement about the quotas. A cartel collapses as soon as the members are no longer prepared to cling to a quota agreement. Mere talk among the owners of m about the desirability of higher prices is of no avail.

As a rule the state of affairs that makes the emergence of monopoly prices possible is brought about by government policies, e.g., customs barriers. If the owners of m do not take advantage of the opportunity to combine for the achievement of monopoly prices offered to them, governments frequently take upon themselves the organization of what the American law calls “restraint of trade.” The police power forces the owners of m—mostly land and mining and fishing facilities—to restrict output. The most eminent examples of this method are provided on the national level by the American farm policy and on the international level by the treaties euphemistically styled Intergovernmental Commodity Control Agreements. There has developed a new semantics to describe this branch of government interference with business. The restriction of output, and consequently of the Edition: current; Page: [362] consumption involved, is called “avoidance of surpluses” and the effect aimed at, a higher price for the unit sold, is called “stabilization.” It is obvious that these quantities of m did not appear as “surpluses” in the eyes of those who would have consumed them. It is also obvious that these people would have preferred a lower price to the “stabilization” of a higher price.

6. The concept of competition does not include the requirement that there should be a multitude of competing units. Competing is always the competition of one man or firm against another man or firm, no matter how many others are striving after the same prize. Competition among the few is not a kind of competition praxeologically different from competition among the many. Nobody ever maintained that the competition for elective office is under a two-party system less competitive than under a system of many parties. The number of competitors plays a role in the analysis of monopoly prices only as far as it is one of the factors upon which the success of the endeavors to unite competitors into a cartel depends.

7. If it is possible for the seller to increase his net proceeds by restricting sales and increasing the price of the units sold, there are usually several monopoly prices that satisfy this condition. As a rule one of these monopoly prices yields the highest net proceeds. But it may also happen that various monopoly prices are equally advantageous to the monopolist. We may call this monopoly price or these monopoly prices most advantageous to the monopolist the optimum monopoly price or the optimum monopoly prices.

8. The monopolist does not know beforehand in what way the consumers will react to a rise in prices. He must resort to trial and error in his endeavors to find out whether the monopolized good can be sold to his advantage at any price exceeding the competitive price and, if this is so, which of various possible monopoly prices is the optimum monopoly price or one of the optimum monopoly prices. This is in practice much more difficult than the economist assumes when, in drawing demand curves, he ascribes perfect foresight to the monopolist. We must therefore list as a special condition required for the appearance of monopoly prices the monopolist’s ability to discover such prices.

9. A special case is provided by the incomplete monopoly. The greater part of the total supply available is owned by the monopolist; the rest is owned by one or several men who are not prepared to cooperate with the monopolist in a scheme for restricting sales and bringing about monopoly prices. However, the reluctance of these outsiders does not prevent the establishment of monopoly prices if Edition: current; Page: [363] the portion p1 controlled by the monopolist is large enough when compared with the sum of the outsiders’ portions p2. Let us assume that the whole supply (p = p1 + p2) can be sold at the price c per unit and a supply of p − z at the monopoly price d. If d (p1 − z) is higher than cp1,itis to the advantage of the monopolist to embark upon a monopolistic restriction of his sales, no matter what the conduct of the outsiders may be. They may go on selling at the price c or they may raise their prices up to the maximum of d. The only point that counts is that the outsiders are not willing to put up with a reduction in the quantity which they themselves are selling. The whole reduction required must be borne by the owner of p1. This influences his plans and will as a rule result in the emergence of a monopoly price which is different from that which would have been established under complete monopoly.14

10.

Duopoly and oligopoly are not special varieties of monopoly prices, but merely a variety of the methods applied for the establishment of a monopoly price. Two or several men own the whole supply. They all are prepared to sell at monopoly prices and to restrict their total sales accordingly. But for some reason they do not want to act in concert. Each of them goes his own way without any formal or tacit agreement with his competitors. But each of them knows also that his rivals are intent upon a monopolistic restriction of their sales in order to reap higher prices per unit and specific monopoly gains. Each of them watches carefully the conduct of his rivals and tries to adjust his own plans to their actions. A succession of moves and countermoves, a mutual outwitting results, the outcome of which depends on the personal cunning of the adverse parties. The duopolists and oligopolists have two objectives in mind: to find out the monopoly price most advantageous to the sellers on the one hand and to shift as much as possible of the burden of restricting the amount of sales to their rivals. Precisely because they do not agree with regard to the quotas of the reduced amount of sales to be allotted to each party, they do not act in concert as the members of a cartel do.

One must not confuse duopoly and oligopoly with the incomplete monopoly or with competition aiming at the establishment of monopoly. In the case of incomplete monopoly only the monopolistic group is prepared to restrict its sales in order to make a monopoly price prevail; the other sellers decline to restrict their sales. But duopolists and oligopolists are ready to withhold a part of their supply from the market. In the case of price slashing one group A plans to attain full Edition: current; Page: [364] monopoly or incomplete monopoly by forcing all or most of its competitors, the B’s, to go out of business. It cuts prices to a level which makes selling ruinous to its more vulnerable competitors. A may also incur losses by selling at this low rate; but it is in a position to undergo such losses for a longer time than the others and it is confident that it will make good for them later by ample monopoly gains. This process has nothing to do with monopoly prices. It is a scheme for the attainment of a monopoly position.

One may wonder whether duopoly and oligopoly are of practical significance. As a rule the parties concerned will come to at least a tacit understanding concerning their quotas of the reduced amount of sales.

11.

The monopolized good by whose partial withholding from the market the monopoly prices are made to prevail can be either a good of the lowest order or a good of a higher order, a factor of production. It may consist in the control of the technological knowledge required for production, the “recipe.” Such recipes are as a rule free goods as their ability to produce definite effects is unlimited. They can become economic goods only if they are monopolized and their use is restricted. Any price paid for the services rendered by a recipe is always a monopoly price. It is immaterial whether the restriction of a recipe’s use is made possible by institutional conditions—such as patents and copyright laws—or by the fact that a formula is kept secret and other people fail to guess it.

The complementary factor of production the monopolization of which can result in the establishment of monopoly prices may also consist in a man’s opportunity to make his cooperation in the production of a good known to consumers who attribute to this cooperation a special significance. This opportunity may be given either by the nature of the commodities or services in question or by institutional provisions such as protection of trademarks. The reasons why the consumers value the contribution of a man or a firm so highly are manifold. They may be special confidence placed on the individual or firm concerned on account of previous experience; 15 merely baseless prejudice or error; snobbishness; magic or metaphysical prepossessions whose groundlessness is ridiculed by more reasonable people. A drug marked by a trademark may not differ in its chemical structure and its physiological efficacy from other compounds not marked with the same label. However, if the buyers attach a special significance to this label and are ready to pay higher prices for the Edition: current; Page: [365] product marked with it, the seller can, provided the configuration of demand is propitious, reap monopoly prices.

The monopoly which enables the monopolist to restrict the amount offered without counteraction on the part of other people can consist in the greater productivity of a factor which he has at his disposal as against the lower productivity of the corresponding factor at the disposal of his potential competitors. If the margin between the higher productivity of his supply of the monopolized factor and that of his potential competitors is broad enough for the emergence of a monopoly price, a situation results which we may call margin monopoly.16

Let us illustrate margin monopoly by referring to its most frequent instance in present-day conditions, the power of a protective tariff to generate a monopoly price under special circumstances. Atlantis puts a tariff t on the importation of each unit of the commodity p, the world market price of which is s. If domestic consumption of p in Atlantis at the price s + t is a and domestic production of p is b, b being smaller than a,then the costs of the marginal dealer are s + t. The domestic plants are in a position to sell their total output at the price s + t. The tariff is effective and offers to domestic business the incentive to expand the production of p from b to a quantity slightly smaller than a. But if b is greater than a, things are different. If we assume that b is so large that even at the price s domestic consumption lags behind it and the surplus must be exported and sold abroad, the imposition of a tariff does not affect the price of p. Both the domestic and the world market price of p remain unchanged. However the tariff, in discriminating between domestic and foreign production of p, accords to the domestic plants a privilege which can be used for a monopolistic combine, provided certain further conditions are present. If it is possible to find within the margin between s + t and s a monopoly price, it becomes lucrative for the domestic enterprises to form a cartel. The cartel sells in the home market of Atlantis at a monopoly price and disposes of the surplus abroad at the world market price. Of course, as the quantity of p offered at the world market increases as a consequence of the restriction of the quantity sold in Atlantis, the world market price drops from s to s1. It is therefore a further requirement for the emergence of the domestic monopoly price that the total restriction in proceeds resulting from this fall in the world market price is not so great as to absorb the whole monopoly gain of the domestic cartel.

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In the long run such a national cartel cannot preserve its monopolistic position if entrance into its branch of production is free to newcomers. The monopolized factor the services of which the cartel restricts (as far as the domestic market is concerned) for the sake of monopoly prices is a geographical condition which can easily be duplicated by every new investor who establishes a new plant within the borders of Atlantis. Under modern industrial conditions, the characteristic feature of which is steady technological progress, the latest plant will as a rule be more efficient than the older plants and produce at lower average costs. The incentive to prospective newcomers is therefore twofold. It consists not only in the monopoly gain of the cartel members, but also in the possibility of outstripping them by lower costs of production.

Here again institutions come to the aid of the old firms that form the cartel. The patents give them a legal monopoly which nobody may infringe. Of course, only some of their production processes may be protected by patents. But a competitor who is prevented from resorting to these processes and to the production of the articles concerned may be handicapped in such a serious way that he cannot consider entrance into the field of the cartelized industry.

The owner of a patent enjoys a legal monopoly which, other conditions being propitious, can be used for the attainment of monopoly prices. Beyond the field covered by the patent itself a patent may render auxiliary services in the establishment and preservation of margin monopoly where the primary institutional conditions for the emergence of such a monopoly prevail.

We may assume that some world cartels would exist even in the absence of any government interference which provides for other commodities the indispensable conditions required for the construction of a monopolistic combine. There are some commodities, e.g., diamonds and mercury, the supply of which is by nature limited to a few sources. The owners of these resources can easily be united for concerted action. But such cartels would play only a minor role in the setting of world production. Their economic significance would be rather small. The important place that cartels occupy in our time is an outcome of the interventionist policies adopted by the governments of all countries. The monopoly problem mankind has to face today is not an outgrowth of the operation of the market economy. It is a product of purposive action on the part of governments. It is not one of the evils inherent in capitalism as the demagogues trumpet. It is, on the contrary, the fruit of policies hostile to capitalism and intent upon sabotaging and destroying its operation.

The classical country of the cartels was Germany. In the last decades Edition: current; Page: [367] of the nineteenth century the German Reich embarked upon a vast scheme of Sozialpolitik [(German) social politics]. The idea was to raise the income and the standard of living of the wage earners by various measures of what is called prolabor legislation, by the much glorified Bismarck scheme of social security, and by labor-union pressure and compulsion for the attainment of higher wage rates. The advocates of this policy defied the warnings of the economists. There is no such thing as economic law, they announced.

In stark reality the Sozialpolitik raised costs of production within Germany. Every progress of the alleged prolabor legislation and every successful strike disarranged industrial conditions to the disadvantage of the German enterprises. It made it harder for them to outdo foreign competitors for whom the domestic events of Germany did not raise costs of production. If the Germans had been in a position to renounce the export of manufactures and to produce only for the domestic market, the tariff could have sheltered the German plants against the intensified competition of foreign business. They would have been in a position to sell at higher prices. What the wage earner would have profited from the achievements of the legislature and the unions, would have been absorbed by the higher prices he would have had to pay for the articles he bought. Real wage rates would have risen only to the extent the entrepreneurs could improve technological procedures and thereby increase the productivity of labor. The tariff would have rendered the Sozialpolitik harmless.

But Germany is, and was already at the time Bismarck inaugurated his prolabor policy, a predominantly industrial country. Its plants exported a considerable part of their total output. These exports enabled the Germans to import the foodstuffs and raw materials they could not grow in their own country, comparatively overpopulated and poorly endowed with natural resources as it was. This situation could not be remedied simply by a protective tariff. Only cartels could free Germany from the catastrophic consequences of its “progressive” prolabor policies. The cartels charged monopoly prices at home and sold abroad at cheaper prices. The cartels are the necessary accompaniment and upshot of a “progressive” labor policy as far as it affects industries dependent for their sales on foreign markets. The cartels do not, of course, safeguard for the wage earners the illusory social gains which the labor politicians and the union leaders promise them. There is no means of raising wage rates for all those eager to earn wages above the height determined by the productivity of each kind of labor. What the cartels achieved was merely to counterbalance the apparent gains in nominal wage rates by corresponding increases in domestic commodity prices. But the most Edition: current; Page: [368] disastrous effect of minimum wage rates, permanent mass unemployment, was at first avoided.

With all industries which cannot content themselves with the domestic market and are intent upon selling a part of their output abroad the function of the tariff, in this age of government interference with business, is to enable the establishment of domestic monopoly prices. Whatever the purpose and the effects of tariffs may have been in the past, as soon as an exporting country embarks upon measures designed to increase the revenues of the wage earners or the farmers above the potential market rates, it must foster schemes which result in domestic monopoly prices for the commodities concerned. A national government’s might is limited to the territory subject to its sovereignty. It has the power to raise domestic costs of production. It does not have the power to force foreigners to pay correspondingly higher prices for the products. If exports are not to be discontinued, they must be subsidized. The subsidy can be paid openly by the treasury or its burden can be imposed upon the consumers by the cartel’s monopoly prices.

The advocates of government interference with business ascribe to the “State” the power to benefit certain groups within the framework of the market by a mere fiat. In fact this power is the government’s power to foster monopolistic combines. The monopoly gains are the funds out of which the “social gains” are financed. As far as these monopoly gains do not suffice, the various measures of interventionism immediately paralyze the operation of the market; mass unemployment, depression, and capital consumption appear. This explains the eagerness of all contemporary governments to foster monopoly in all those sectors of the market which are in some way or other connected with export trade.

If a government does not or cannot succeed in attaining its monopolistic aims indirectly, it resorts to other means. In the field of coal and potash the Imperial Government of Germany fostered compulsory cartels. The American New Deal was prevented by the opposition of business from organizing the nation’s great industries on an obligatory cartel basis. It fared better in some vital branches of farming with measures designed to restrict output for the sake of monopoly prices. A long series of agreements concluded between the world’s most prominent governments aimed at the establishment of world-market monopoly prices for various raw materials and foodstuffs.17 It is the avowed purpose of the United Nations to continue these plans.

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12.

It is necessary to view this promonopoly policy of the contemporary governments as a uniform phenomenon in order to discern the reasons which motivated it. From the catallactic point of view these monopolies are not uniform. The contractual cartels into which entrepreneurs enter in taking advantage of the incentive offered by protective tariffs are instances of margin monopoly. Where the government directly fosters monopoly prices we are faced with instances of license monopoly. The factor of production by the restriction of the use of which the monopoly price is brought about is the license18 which the laws make a requisite for supplying the consumers.

Such licenses may be granted in different ways:

(a) An unlimited license is granted to practically every applicant. This amounts to a state of affairs under which no license at all is required.

(b) Licenses are granted only to selected applicants. Competition is restricted. However, monopoly prices can emerge only if the licensees act in concert and the configuration of demand is propitious.

(c) There is only one licensee. The licensee, e.g., the holder of a patent or a copyright, is a monopolist. If the configuration of the demand is propitious and if the licensee wants to reap monopoly gains, he can ask monopoly prices.

(d) The licenses granted are limited. They confer upon the licensee only the right to produce or to sell a definite quantity, in order to prevent him from disarranging the authority’s scheme. The authority itself directs the establishment of monopoly prices.

Finally there are the instances in which a government establishes a monopoly for fiscal purposes. The monopoly gains go to the treasury. Many European governments have instituted tobacco monopolies. Others have monopolized salt, matches, telegraph and telephone service, broadcasting, and so on. Without exception every country has a government monopoly of the postal service.

13.

Margin monopoly need not always owe its appearance to an institutional factor such as tariffs. It can also be produced by sufficient differences in the fertility or productivity of some factors of production.

It has already been said that it is a serious blunder to speak of a land monopoly and to refer to monopoly prices and monopoly gains in explaining the prices of agricultural products and the rent of land. As far as history is confronted with instances of monopoly prices for agricultural products, it was license monopoly fostered by government Edition: current; Page: [370] decree. However, the acknowledgement of these facts does not mean that differences in the fertility of the soil could never bring about monopoly prices. If the difference between the fertility of the poorest soil still tilled and the richest fallow fields available for an expansion of production were so great as to enable the owners of the already exploited soil to find an advantageous monopoly price within this margin, they could consider restricting production by concerted action in order to reap monopoly prices. But it is a fact that physical conditions in agriculture do not comply with these requirements. It is precisely on account of this fact that farmers longing for monopoly prices do not resort to spontaneous action but ask for the interference of governments.

In various branches of mining, conditions are often more propitious for the emergence of monopoly prices based on margin monopoly.

14.

It has been asserted again and again that the economies of big-scale production have generated a tendency toward monopoly prices in the processing industries. Such a monopoly would be called in our terminology a margin monopoly.

Before entering into a discussion of this topic one must clarify the role an increase or decrease in the unit’s average cost of production plays in the considerations of a monopolist searching for the most advantageous monopoly price. We consider a case in which the owner of a monopolized complementary factor of production, e.g., a patent, at the same time manufactures the product p. If the average cost of production of one unit of p, without any regard to the patent, decreases with the increase in the quantity produced, the monopolist must weigh this against the gains expected from the restriction of output. If, on the other hand, cost of production per unit decreases with the restriction of total production, the incentive to embark upon monopolistic restraint is augmented. It is obvious that the mere fact that big-scale production tends as a rule to lower average costs of production is in itself not a factor driving toward the emergence of monopoly prices. It is rather a checking factor.

What those who blame the economies of big-scale production for the spread of monopoly prices are trying to say is that the higher efficiency of big-scale production makes it difficult or even impossible for small-scale plants to compete successfully. A big-scale plant could, they believe, resort to monopoly prices with impunity because small business is not in a position to challenge its monopoly. Now, it is certainly true that in many branches of the processing industries it would be foolish to enter the market with the high-cost products of small, inadequate plants. A modern cotton mill does not need to fear the Edition: current; Page: [371] competition of old-fashioned distaffs; its rivals are other more or less adequately equipped mills. But this does not mean that it enjoys the opportunity of selling at monopoly prices. There is competition between big businesses too. If monopoly prices prevail in the sale of the products of big-size business, the reasons are either patents or monopoly in the ownership of mines or other sources of raw material or cartels based on tariffs.

One must not confuse the notions of monopoly and of monopoly prices. Mere monopoly as such is catallactically of no importance if it does not result in monopoly prices. Monopoly prices are consequential only because they are the outcome of a conduct of business defying the supremacy of the consumers and substituting the private interests of the monopolist for those of the public. They are the only instance in the operation of a market economy in which the distinction between production for profit and production for use could to some extent be made if one were prepared to disregard the fact that monopoly gains have nothing at all to do with profits proper. They are not a part of what catallactics can call profits; they are an increase in the price earned from the sale of the services rendered by some factors of production, some of these factors being physical factors, some of them merely institutional. If the entrepreneurs and capitalists in the absence of a monopoly price constellation abstain from expanding production in a certain branch of industry because the opportunities offered to them in other branches are more attractive, they do not act in defiance of the wants of the consumers. On the contrary, they follow precisely the line indicated by the demand as expressed on the market.

The political bias which has obfuscated the discussion of the monopoly problem has neglected to pay attention to the essential issues involved. In dealing with every case of monopoly prices one must first of all raise the question of what obstacles restrain people from challenging the monopolists. In answering this question one discovers the role played in the emergence of monopoly prices by institutional factors. It was nonsense to speak of conspiracy with regard to the deals between American firms and German cartels. If an American wanted to manufacture an article protected by a patent owned by Germans, he was compelled by the American law to come to an arrangement with German business.

15.

A special case is what may be called the failure monopoly.

In the past capitalists invested funds in a plant designed for the production of the article p. Later events proved the investment a failure. The prices which can be obtained in selling p are so low that Edition: current; Page: [372] the capital invested in the plant’s inconvertible equipment does not yield a return. It is lost. However, these prices are high enough to yield a reasonable return for the variable capital to be employed for the current production of p. If the irrevocable loss of the capital invested in the inconvertible equipment is written off on the books and all corresponding alterations are made in the accounts, the reduced capital working in the conduct of the business is by and large so profitable that it would be a new mistake to stop production altogether. The plant works at full capacity producing the quantity q of p and selling the unit at the price s.

But conditions may be such that it is possible for the enterprise to reap a monopoly gain by restricting output to q/2 and selling the unit of q at the price 3 s. Then the capital invested in the inconvertible equipment no longer appears completely lost. It yields a modest return, namely, the monopoly gain.

This enterprise now sells at monopoly prices and reaps monopoly gains although the total capital invested yields little when compared with what the investors would have earned if they had invested in other lines of business. The enterprise withholds from the market the services which the unused production capacity of its durable equipment could render and fares better than it would by producing at full capacity. It defies the orders of the public. The public would have been in a better position if the investors had avoided the mistake of immobilizing a part of their capital in the production of p. They would, of course, not get any p. But they would instead obtain those articles which they miss now because the capital required for their production has been wasted in the construction of an aggregate for the production of p. However, as things are now after this irreparable fault has been committed, they want to get more of p and are ready to pay for it what is now its potential competitive market price, namely, s. They do not approve, as conditions are now, the action of the enterprise in withholding an amount of variable capital from employment for the production of p. This amount certainly does not remain unused. It goes into other lines of business and produces there something else, namely, m. But as conditions are now, the consumers would prefer an increase of the available quantity of p to an increase in the available quantity of m.The proof is that in the absence of a monopolistic restriction of the capacity for the production of p, as it is under given conditions, the profitability of a production of the quantity q selling at the price s would be such that it would pay better than an increase in the quantity of the article m produced.

There are two distinctive features of this case. First, the monopoly Edition: current; Page: [373] prices paid by the buyers are still lower than the total cost of production of p would be if full account is taken of the whole input of the investors. Second, the monopoly gains of the firm are so small that they do not make the total venture appear a good investment. It remains malinvestment. It is precisely this fact that constitutes the monopolistic position of the firm. No outsider wants to enter its field of entrepreneurial activity because the production of p results in losses.

Failure monopoly is by no means a merely academic construction. It is, for instance, actual today in the case of some railroad companies. But one must guard against the mistake of interpreting every instance of unused production capacity as a failure monopoly. Even in the absence of monopoly it may be more profitable to employ variable capital for other purposes instead of expanding a firm’s production to the limit fixed by the capacity of its durable inconvertible equipment; then the output restriction complies precisely with the state of the competitive market and the wishes of the public.

16.

Local monopolies are, as a rule, of institutional origin. But there are also local monopolies which originate out of conditions of the unhampered market. Often the institutional monopoly is designed to deal with a monopoly which came into existence or would be likely to come into existence without any authoritarian interference with the market.

A catallactic classification of local monopolies must distinguish three groups: margin monopoly, limited-space monopoly and license monopoly.

A local margin monopoly is characterized by the fact that the barrier preventing outsiders from competing on the local market and breaking the monopoly of the local sellers is the comparative height of transportation costs. No tariffs are needed to grant limited protection to a firm which owns all the adjacent natural resources required for the production of bricks against the competition of far distant tile works. The costs of transportation provide them with a margin in which, the configuration of demand being propitious, an advantageous monopoly price can be found.

So far local margin monopolies do not differ catallactically from other instances of margin monopoly. What distinguishes them and makes it necessary to deal with them in a special way is their relation to the rent of urban land on the one hand and their relation to city development on the other.

Let us assume that an area A offering favorable conditions for the aggregation of an increasing urban population is subject to monopoly prices for building materials. Consequently building costs are higher than they would be in the absence of such a monopoly. But there is no reason for those weighing the pros and cons of choosing the location of their homes and their workshops in A to pay higher Edition: current; Page: [374] prices for the purchase or the renting of such houses and workshops. These prices are determined on the one hand by the corresponding prices in other areas and on the other by the advantages which settling in A offers when compared with settling somewhere else. The higher expenditure required for construction does not affect these prices; its incidence falls upon the yield of land. The burden of the monopoly gains of the sellers of building materials falls on the owners of the urban soil. These gains absorb proceeds which in their absence would go to these owners. Even in the—not very likely—case that the demand for houses and workshops is such as to make it possible for the owners of the land to attain monopoly prices in selling and leasing, the monopoly prices of the building materials would affect only the proceeds of the landowners, not the prices to be paid by the buyers or tenants.

The fact that the burden of the monopoly gains reverts to the price of urban employment of the land does not mean that it does not check the growth of the city. It postpones the employment of the peripheral land for the expansion of the urban settlement. The instant at which it becomes advantageous for the owner of a piece of suburban land to withdraw it from agricultural or other nonurban employment and to use it for urban development appears at a later date.

Now arresting a city’s development is a two-edged action. Its usefulness for the monopolist is ambiguous. He cannot know whether future conditions will be such as to attract more people to A, the only market for his products. One of the attractions a city offers to newcomers is its bigness, the multitude of its population. Industry and commerce tend toward centers. If the monopolist’s action delays the growth of the urban community, it may direct the stream toward other places. An opportunity may be missed which never comes back. Greater proceeds in the future may be sacrificed to comparatively small short-run gains.

It is therefore at least questionable whether the owner of a local margin monopoly in the long run serves his own interests well by embarking upon selling at monopoly prices. It would often be more advantageous for him to discriminate between the various buyers. He could sell at higher prices for construction projects in the central parts of the city and at lower prices for such projects in peripheral districts. The range of local margin monopoly is more restricted than is generally assumed.

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Limited-space monopoly is the outcome of the fact that physical conditions restrict the field of operation in such a way that only one or a few enterprises can enter it. Monopoly emerges when there is only one enterprise in the field or when the few operating enterprises combine for concerted action.

It is sometimes possible for two competing trolley companies to operate in the same streets of a city. There were instances in which two or even more companies shared in supplying the residents of an area with gas, electricity, and telephone service. But even in such exceptional cases there is hardly any real competition. Conditions suggest to the rivals that they combine at least tacitly. The narrowness of the space results, one way or another, in monopoly.

In practice limited-space monopoly is closely connected with license monopoly. It is practically impossible to enter the field without an understanding with the local authorities controlling the streets and their subsoil. Even in the absence of laws requiring a franchise for the establishment of public utility services, it would be necessary for the enterprises to come to an agreement with the municipal authorities. Whether or not such agreements are to be legally described as franchises is unimportant.

Monopoly, of course, need not result in monopoly prices. It depends on the special data of each case whether or not a monopolistic public utility company could resort to monopoly prices. But there are certainly cases in which it can. It may be that the company is ill-advised in choosing a monopoly-price policy and that it would better serve its long-run interests by lower prices. But there is no guarantee that a monopolist will find out what is most advantageous for him.

One must realize that limited-space monopoly may often result in monopoly prices. In this case we are confronted with a situation in which the market process does not accomplish its democratic function.19

Private enterprise is very unpopular with our contemporaries. Private ownership of the means of production is especially disliked in those fields in which limited-space monopoly emerges even if the company does not charge monopoly prices and even if its business yields only small profits or results in losses. A “public utility” company is in the eyes of the interventionist and socialist politicians a public enemy. The voters approve of any evil inflicted upon it by the authorities. It is generally assumed that these enterprises should be nationalized or municipalized. Monopoly gains, it is said, must Edition: current; Page: [376] never go to private citizens. They should go to the public funds exclusively.

The outcome of the municipalization and nationalization policies of the last decades was almost without exception financial failure, poor service, and political corruption. Blinded by their anticapitalistic prejudices people condone poor service and corruption and for a long time did not bother about the financial failure. However, this failure is one of the factors which contributed to the emergence of the present-day crisis of interventionism.20

17.

It is customary to characterize labor-union policies as monopolistic schemes aiming at the substitution of monopoly wage rates for competitive wage rates. However, as a rule labor unions do not aim at monopoly wage rates. A union is intent upon restricting competition on its own sector of the labor market in order to raise its wage rates. But restriction of competition and monopoly price policy must not be confused. The characteristic feature of monopoly prices is the fact that the sale of only apart p of the total supply P available nets higher proceeds than the sale of P. The monopolist earns a monopoly gain by withholding P p from the market. It is not the height of this gain that marks the monopoly price situation as such, but the purposive action of the monopolists in bringing it about. The monopolist is concerned with the employment of the whole stock available. He is equally interested in every fraction of this stock. If a part of it remains unsold, it is his loss. Nonetheless he chooses to have a part unused because under the prevailing configuration of demand it is more advantageous for him to proceed in this way. It is the peculiar state of the market that motivates his decision. The monopoly which is one of the two indispensable conditions of the emergence of monopoly prices may be—and is as a rule—the product of an institutional interference with the market data. But these external forces do not directly result in monopoly prices. Only if a second requirement is fulfilled is the opportunity for monopolistic action set.

It is different in the case of simple supply restriction. Here the authors of the restriction are not concerned with what may happen to the part of the supply they bar from access to the market. The fate of the people who own this part does not matter to them. They are looking only at that part of the supply which remains on the market. Monopolistic action is advantageous for the monopolist only if total net proceeds at a monopoly price exceed total net proceeds at the potential competitive price. Restrictive action on the other hand is Edition: current; Page: [377] always advantageous for the privileged group and disadvantageous for those whom it excludes from the market. It always raises the price per unit and therefore the total net proceeds of the privileged group. The losses of the excluded group are not taken into account by the privileged group.

It may happen that the benefits which the privileged group derives from the restriction of competition are much more lucrative for them than any imaginable monopoly price policy could be. But this is another question. It does not blot out the catallactic differences between these two modes of action.

The labor unions aim at a monopolistic position on the labor market. But once they have attained it, their policies are restrictive and not monopoly price policies. They are intent upon restricting the supply of labor in their field without bothering about the fate of those excluded. They have succeeded in every comparatively underpopulated country in erecting immigration barriers. Thus they preserve their comparatively high wage rates. The excluded foreign workers are forced to stay in their countries in which the marginal productivity of labor, and consequently wage rates, are lower. The tendency toward an equalization of wage rates which prevails under free mobility of labor from country to country is paralyzed. On the domestic market the unions do not tolerate the competition of non-unionized workers and admit only a restricted number to union membership. Those not admitted must go into less remunerative jobs or must remain unemployed. The unions are not interested in the fate of these people.

Even if a union takes over the responsibility for its unemployed members and pays them, out of contributions of its employed members, unemployment doles not lower than the earnings of the employed members, its action is not a monopoly price policy. For the unemployed union members are not the only people whose earning power is adversely affected by the union’s policy of substituting higher rates for the potential lower market rates. The interests of those excluded from membership are not taken into account.

The Mathematical Treatment of the Theory of Monopoly Prices

Mathematical economists have paid special attention to the theory of monopoly prices. It looks as if monopoly prices would be a chapter of catallactics for which mathematical treatment is more appropriate than it is for other chapters of catallactics. However, the services which mathematics can render in this field are rather poor too.

With regard to competitive prices mathematics cannot give more than a mathematical description of various states of equilibrium and Edition: current; Page: [378] of conditions in the imaginary construction of the evenly rotating economy. It cannot say anything about the actions which would finally establish these equilibria and this evenly rotating system if no further changes in the data were to occur.

In the theory of monopoly prices mathematics comes a little nearer to the reality of action. It shows how the monopolist could find out the optimum monopoly price provided he had at his disposal all the data required. But the monopolist does not know the shape of the curve of demand. What he knows is only points at which the curves of demand and supply intersected one another in the past. He is therefore not in a position to make use of the mathematical formulas in order to discover whether there is any monopoly price for his monopolized article and, if so, which of various monopoly prices is the optimum price. The mathematical and graphical disquisitions are therefore no less futile in this sector of action than in any other sector. But, at least, they schematize the deliberations of the monopolist and do not, as in the case of competitive prices, satisfy themselves in describing a merely auxiliary construction of theoretical analysis which does not play a role in real action.

Contemporary mathematical economists have confused the study of monopoly prices. They consider the monopolist not as the seller of a monopolized commodity, but as an entrepreneur and producer. However, it is necessary to distinguish the monopoly gain clearly from entrepreneurial profit. Monopoly gains can only be reaped by the seller of a commodity or a service. An entrepreneur can reap them only in his capacity as seller of a monopolized commodity, not in his entrepreneurial capacity. The advantages and disadvantages which may result from the fall or rise in cost of production per unit with increasing total production, diminish or increase the monopolist’s total net proceeds and influence his conduct. But the catallactic treatment of monopoly prices must not forget that the specific monopoly gain stems, with due allowance made to the configuration of demand, only from the monopoly of a commodity or a right. It is this alone which affords to the monopolist the opportunity to restrict supply without fear that other people can frustrate his action by expanding the quantity they offer for sale. Attempts to define the conditions required for the emergence of monopoly prices by resorting to the configuration of production costs are vain.

It is misleading to describe the market situation resulting in competitive prices by declaring that the individual producer could sell at the market price also a greater quantity than what he really sells. This is true only when two special conditions are fulfilled: the producer concerned, A, is not the marginal producer, and expanding production does not require additional costs which cannot be recovered in selling the additional quantity of products. Then A’s expansion Edition: current; Page: [379] forces the marginal producer to discontinue production; the supply offered for sale remains unchanged.

The characteristic mark of the competitive price as distinguished from the monopoly price is that the former is the outcome of a situation under which the owners of goods and services of all orders are compelled to serve best the wishes of the consumers. On a competitive market there is no such thing as a price policy of the sellers. They have no alternative other than to sell as much as they can at the highest price offered to them. But the monopolist fares better by withholding from the market a part of the supply at his disposal in order to make specific monopoly gains.

7: Good Will

It must be emphasized again that the market is peopled by men who are not omniscient and have only a more or less defective knowledge of prevailing conditions.

The buyer must always rely upon the trustworthiness of the seller. Even in the purchase of producers’ goods the buyer, although as a rule an expert in the field, depends to some extent on the reliability of the seller. This is still more the case on the market for consumers’ goods. Here the seller for the most part excels the buyer in technological and commercial insight. The salesman’s task is not simply to sell what the customer is asking for. He must often advise the customer how to choose the merchandise which can best satisfy his needs. The retailer is not only a vendor; he is also a friendly helper. The public does not heedlessly patronize every shop. If possible, a man prefers a store or a brand with which he himself or trustworthy friends have had good experience in the past.

Good will is the renown a business acquires on account of past achievements. It implies the expectation that the bearer of the good will in the future will live up to his earlier standards. Good will is not a phenomenon appearing only in business relations. It is present in all social relations. It determines a person’s choice of his spouse and of his friends and his voting for a candidate in elections. Catallactics, of course, deals only with commercial good will.

It does not matter whether the good will is based on real achievements and merits or whether it is only a product of imagination and fallacious ideas. What counts in human action is not truth as it may appear to an omniscient being, but the opinions of people liable to error. There are some instances in which customers are prepared to pay a higher price for a special brand of a compound although the branded article does not differ in its physical and chemical structure from another cheaper product. Experts may deem such conduct unreasonable. Edition: current; Page: [380] But no man can acquire expertness in all fields which are relevant for his choices. He cannot entirely avoid substituting confidence in men for knowledge of the true state of affairs. The regular customer does not always select the article or the service, but the purveyor whom he trusts. He pays a premium to those whom he considers reliable.

The role which good will plays on the market does not impair or restrict competition. Everybody is free to acquire good will, and every bearer of good will can lose good will once acquired. Many reformers, impelled by their bias for paternal government, advocate authoritarian grade labeling as a substitute for trademarks. They would be right if rulers and bureaucrats were endowed with omniscience and perfect impartiality. But as officeholders are not free from human weakness, the realization of such plans would merely substitute the defects of government appointees for those of individual citizens. One does not make a man happier by preventing him from discriminating between a brand of cigarettes or canned food he prefers and another brand he likes less.

The acquisition of good will requires not only honesty and zeal in attending to the customers, but no less money expenditure. It takes time until a firm has acquired a steady clientele. In the interval it must often put up with losses against which it balances expected later profits.

From the point of view of the seller good will is, as it were, a necessary factor of production. It is appraised accordingly. It does not matter that as a rule the money equivalent of the good will does not appear in book entries and balance sheets. If a business is sold, a price is paid for the good will provided it is possible to transfer it to the acquirer.

It is consequently a problem of catallactics to investigate the nature of this peculiar thing called good will. In this scrutiny we must distinguish three different cases.

Case 1. The good will gives to the seller the opportunity to sell at monopoly prices or to discriminate among various classes of buyers. This does not differ from other instances of monopoly prices or price discrimination.

Case 2. The good will gives to the seller merely the opportunity to sell at prices corresponding to those which his competitors attain. If he had no good will, he would not sell at all or only by cutting prices. Good will is for him no less necessary than the business premises, the keeping of a well-assorted stock of merchandise and the hiring of skilled helpers. The costs incurred by the acquisition of Edition: current; Page: [381] good will play the same role as any other business expenses. They must be defrayed in the same way by an excess of total proceeds over total costs.

Case 3. The seller enjoys within a limited circle of staunch patrons such a brilliant reputation that he can sell to them at higher prices than those paid to his less renowned competitors. However, these prices are not monopoly prices. They are not the result of a deliberate policy aiming at a restriction in total sales for the sake of raising total net proceeds. It may be that the seller has no opportunity whatsoever to sell a larger quantity, as is the case for example, with a doctor who is busy to the limit of his powers although he charges more than his less popular colleagues. It may also be that the expansion of sales would require additional capital investment and that the seller either lacks this capital or believes that he has a more profitable employment for it. What prevents an expansion of output and of the quantity of merchandise or services offered for sale is not a purposive action on the part of the seller, but the state of the market.

As the misinterpretation of these facts has generated a whole mythology of “imperfect competition” and “monopolistic competition,” it is necessary to enter into a more detailed scrutiny of the considerations of an entrepreneur who is weighing the pros and cons of an expansion of his business.

Expansion of a production aggregate, and no less increasing production from partial utilization of such an aggregate to full capacity production, requires additional capital investment which is reasonable only if there is no more profitable investment available.21 It does not matter whether the entrepreneur is rich enough to invest his own funds or whether he would have to borrow the funds needed. Also that part of an entrepreneur’s own capital which is not employed in his firm is not “idle.” It is utilized somewhere in the framework of the economic system. In order to be employed for the expansion of the business concerned these funds must be withdrawn from their present employment.22 The entrepreneur will only embark upon this change of investment if he expects from it an increase in his net returns. In addition there are other doubts which may check the propensity to expand a prospering enterprise even if the market situation seems to offer propitious chances. The entrepreneur may Edition: current; Page: [382] mistrust his own ability to manage a bigger outfit successfully. He may also be frightened by the example provided by once prosperous enterprises for which expansion resulted in failure.

A businessman who, thanks to his splendid good will, is in a position to sell at higher prices than less renowned competitors, could, of course, renounce his advantage and reduce his prices to the level of his competitors. Like every seller of commodities or of labor he could abstain from taking fullest advantage of the state of the market and sell at a price at which demand exceeds supply. In doing so he would be making presents to some people. The donees would be those who could buy at this lowered price. Others, although ready to buy at the same price, would have to go away empty-handed because the supply was not sufficient.

The restriction of the quantity of every article produced and offered for sale is always the outcome of the decisions of entrepreneurs intent upon reaping the highest possible profit and avoiding losses. The characteristic mark of monopoly prices is not to be seen in the fact that the entrepreneurs did not produce more of the article concerned and thus did not bring about a fall in its price. Neither is it to be seen in the fact that complementary factors of production remain unused although their fuller employment would have lowered the price of the product. The only relevant question is whether or not the restriction of production is the outcome of the action of the—monopolistic—owner of a supply of goods and services who withholds a part of this supply in order to attain higher prices for the rest. The characteristic feature of monopoly prices is the monopolist’s defiance of the wishes of the consumers. A competitive price for copper means that the final price of copper tends toward a point at which the deposits are exploited to the extent permitted by the prices of the required nonspecific complementary factors of production; the marginal mine does not yield mining rent. The consumers are getting as much copper as they themselves determine by the prices they allow for copper and all other commodities. A monopoly price of copper means that the deposits of copper are utilized only to a smaller degree because this is more advantageous to the owners; capital and labor which, if the supremacy of the consumers were not infringed, would have been employed for the production of additional copper, are employed for the production of other articles for which the demand of the consumers is less intense. The interests of the owners of the copper deposits take precedence over those of the consumers. The available resources of copper are not employed according to the wishes and plans of the public.

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Profits are, of course, also the outcome of a discrepancy between the wishes of the consumers and the actions of the entrepreneurs. If all entrepreneurs had had in the past perfect foresight of the present state of the market, no profits and losses would have emerged. Their competition would have already adjusted in the past—due allowance being made for time preference—the prices of the complementary factors of production to the present prices of the products. But this statement cannot brush away the fundamental difference between profits and monopoly gains. The entrepreneur profits to the extent he has succeeded in serving the consumers better than other people have done. The monopolist reaps monopoly gains through impairing the satisfaction of the consumers.

8: Monopoly of Demand

Monopoly prices can emerge only from a monopoly of supply. A monopoly of demand does not bring about a market situation different from that under not monopolized demand. The monopolistic buyer—whether he is an individual or a group of individuals acting in concert—cannot reap a specific gain corresponding to the monopoly gains of monopolistic sellers. If he restricts demand, he will buy at a lower price. But then the quantity bought will drop too.

In the same way in which governments restrict competition in order to improve the position of privileged sellers, they can also restrict competition for the benefit of privileged buyers. Again and again governments have put an embargo on the export of certain commodities. Thus by excluding foreign buyers they have aimed at lowering the domestic price. But such a lower price is not a counterpart of monopoly prices.

What is commonly dealt with as monopoly of demand are certain phenomena of the determination of prices for specific complementary factors of production.

The production of one unit of the commodity m requires, besides the employment of various nonspecific factors, the employment of one unit of each of the two absolutely specific factors a and b. Neither a nor b can be replaced by any other factor; on the other hand a is of no use when not combined with b and vice versa. The available supply of a by far exceeds the available supply of b. It is therefore not possible for the owners of a to attain any price for a. The demand for a always lags behind the supply; a is not an economic good. If a is a mineral deposit the extraction of which requires the use of capital and labor, the ownership of the deposits does not yield a royalty. There is no mining rent.

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But if the owners of a form a cartel, they can turn the tables. They can restrict the supply of a offered for sale to such a fraction that the supply of b exceeds the supply of a. Now a becomes an economic good for which prices are paid while the price of b dwindles to zero. If then the owners of b react by forming a cartel too, a price struggle develops between the two monopolistic combines about the outcome of which catallactics can make no statements. As has already been pointed out, the pricing process does not bring about a uniquely determined result in cases in which more than one of the factors of production required is of an absolutely specific character.

It does not matter whether or not the market situation is such that the factors a and b together could be sold at monopoly prices. It does not make any difference whether the price for a lot including one unit of both a and b is a monopoly price or a competitive price.

Thus what is sometimes viewed as a monopoly of demand turns out to be a monopoly of supply formed under particular conditions. The sellers of a and b are intent upon selling at monopoly prices without regard to the question whether or not the price of m can become a monopoly price. What alone matters for them is to obtain as great a share as possible of the joint price which the buyers are ready to pay for a and b together. The case does not indicate any feature which would make it permissible to apply to it the term monopoly of demand. This mode of expression becomes understandable, however, if one takes into account the accidental features marking the contest between the two groups. If the owners of a (or b) are at the same time the entrepreneurs conducting the processing of m, their cartel takes on the outward appearance of a monopoly of demand. But this personal union combining two separate catallactic functions does not alter the essential issue; what is at stake is the settlement of affairs between two groups of monopolistic sellers.

Our example fits, mutatis mutandis, the case in which a and b can also be employed for purposes other than the production of m, provided these other employments only yield smaller returns.

9: Consumption as Affected by Monopoly Prices

The individual consumer may react to monopoly prices in different ways.

1. Not with standing the rise in price, the individual consumer does not restrict his purchases of the monopolized article. He prefers to restrict the purchase of other goods. (If all consumers were to react in this way, the competitive price would have already risen to the height of the monopoly price.) Edition: current; Page: [385]

2. The consumer restricts his purchase of the monopolized article to such an extent that he does not spend for it more than he would have spent—for the purchase of a larger quantity—under the competitive price. (If all people were to react in this way, the seller would not get more under the monopoly price than he did under the competitive price; he would not derive any gain by deviating from the competitive price.)

3. The consumer restricts his purchase of the monopolized commodity to such an extent that he spends less for it than he would have spent under the competitive price; he buys with the money thus saved goods which he would not have bought otherwise. (If all people were to react in this way, the seller would harm his interests by substituting a higher price for the competitive price; no monopoly price could emerge. Only a benefactor who wanted to wean his fellow men from the consumption of pernicious drugs would in this case raise the price of the article concerned above the competitive level.)

4. The consumer spends more for the monopolized commodity than he would have spent under the competitive price and acquires only a smaller quantity of it.

However the consumer may react, his satisfaction appears to be impaired from the viewpoint of his own valuations. He is not so well served under monopoly prices as under competitive prices. The monopoly gain of the seller is borne by a monopoly deprivation of the buyer. Even if some consumers (as in case 3) acquire goods which they would not have bought in the absence of the monopoly price, their satisfaction is lower than it would have been under a different state of prices. Capital and labor which are withdrawn from the production of products which drops on account of the monopolistic restriction of the supply of one of the complementary factors required for their production, are employed for the production of other things which would otherwise not have been produced. But the consumers value these other things less.

Yet there is an exception to this general rule that monopoly prices benefit the seller and harm the buyer and infringe the supremacy of the consumers’ interests. If on a competitive market one of the complementary factors, namely f, needed for the production of the consumers’ good g, does not attain any price at all, although the production of f requires various expenditures and consumers are ready to pay for the consumers’ good g a price which makes its production profitable on a competitive market, the monopoly price for f becomes a necessary requirement for the production of g. It is this idea that Edition: current; Page: [386] people advance in favor of patent and copyright legislation. If inventors and authors were not in a position to make money by inventing and writing, they would be prevented from devoting their time to these activities and from defraying the costs involved. The public would not derive any advantage from the absence of monopoly prices for f. It would, on the contrary, miss the satisfaction it could derive from the acquisition of g.23

Many people are alarmed by the reckless use of the deposits of minerals and oil which cannot be replaced. Our contemporaries, they say, squander an exhaustible stock without any regard for the coming generations. We are consuming our own birthright and that of the future. Now these complaints make little sense. We do not know whether later ages will still rely upon the same raw materials on which we depend today. It is true that the exhaustion of the oil deposits and even those of coal is progressing at a quick rate. But it is very likely that in a hundred or five hundred years people will resort to other methods of producing heat and power. Nobody knows whether we, in being less profligate with these deposits, would not deprive ourselves without any advantage to men of the twenty-first or of the twenty-fourth centuries. It is vain to provide for the needs of ages the technological abilities of which we cannot even dream.

But it is contradictory if the same people who lament the depletion of some natural resources are no less vehement in indicting monopolistic restraint in their present-day exploitation. The effect of monopoly prices of mercury is certainly a slowing down of the rate of depletion. In the eyes of those frightened by the aspect of a future scarcity of mercury this effect must appear highly desirable.

Economics in unmasking such contradictions does not aim at a “justification” of monopoly prices for oil, minerals, and ore. Economics has neither the task of justifying nor of condemning. It has merely to scrutinize the effects of all modes of human action. It does not enter the arena in which friends and foes of monopoly prices are intent upon pleading their causes.

Both sides in this heated controversy resort to fallacious arguments. The antimonopoly party is wrong in attributing to every monopoly the power to impair the situation of the buyers by restricting supply and bringing about monopoly prices. It is no less wrong in assuming that there prevails within a market economy, not hampered and sabotaged by government interference, a general tendency toward the formation of monopoly. It is a grotesque distortion of the true Edition: current; Page: [387] state of affairs to speak of monopoly capitalism instead of monopoly interventionism and of private cartels instead of government-made cartels. Monopoly prices would be limited to some minerals which can be mined in only a few places and to the field of local limited-space monopolies if the governments were not intent upon fostering them.24

The promonopoly party is wrong in crediting to the cartels the economics of big-scale production. Monopolistic concentration of production on one hand, they say, as a rule reduces average costs of production and thus increases the amount of capital and labor available for additional production. However, no cartel is needed in order to eliminate the plants producing at higher costs. Competition on the free market achieves this effect in the absence of any monopoly and of any monopoly prices. It is, on the contrary, often the purpose of government-sponsored cartelization to preserve the existence of plants and farms which the free market would force to discontinue operations precisely because they are producing at too high costs of production. The free market would have eliminated, for example, the submarginal farms and preserved only those for which production pays under the prevailing market price. But the New Deal preferred a different arrangement. It forced all farmers to a proportional restriction of output. It raised by its monopolistic policy the price of agricultural products to such a height that production became reasonable again on submarginal soil.

No less erroneous are the conclusions derived from a confusion of the economies of product standardization and monopoly. If men asked only for one standard type of a definite commodity, production of some articles could be arranged in a more economical way and costs would be lowered accordingly. But if people were to behave in such a manner, standardization and the corresponding cost reduction would emerge also in the absence of monopoly. If, on the other hand, one forces the consumers to be content with one standard type only, one does not increase their satisfaction; one impairs it. A dictator may deem the conduct of the consumers rather foolish. Why should not women be dressed in uniforms like soldiers? Why should they be so crazy about individually fashioned clothes? He may be right from the point of view of his own value judgments. But the trouble is that valuation is personal, individual, and arbitrary. The democracy of the market consists in the fact that people themselves make their choices and that no dictator has the power to force them to submit to his value judgments.

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10: Price Discrimination on the Part of the Seller

Both competitive prices and monopoly prices are the same for all buyers. There prevails on the market a permanent tendency to eliminate all discrepancies in prices for the same commodity or service. Although the valuations of the buyers and the intensity of their demand as effective on the market are different, they pay the same prices. The wealthy man does not pay more for bread than the less wealthy man, although he would be ready to pay a higher price if he could not buy it cheaper. The enthusiast who would rather restrict his consumption of food than miss a performance of a Beethoven symphony pays no more for admission than a man for whom music is merely a pastime and who would not care for the concert if he could attend it only by renouncing his desire for some trifles. The difference between the price one must pay for a good and the highest amount one would be prepared to pay for it has sometimes been called consumers’ surplus.25

But there can appear on the market conditions which make it possible for the seller to discriminate between the buyers. He can sell a commodity or a service at different prices to different buyers. He can obtain prices which may sometimes even rise to the point at which the whole consumers’ surplus of a buyer disappears. Two conditions must coincide in order to make price discrimination advantageous to the seller.

The first condition is that those buying at a cheaper price are not in a position to resell the commodity or the service to people to whom the discriminating seller sells only at a higher price. If such reselling cannot be prevented, the first seller’s intention would be thwarted. The second condition is that the public does not react in such a way that the total net proceeds of the seller lag behind the total net proceeds he would obtain under price uniformity. This second condition is always present under conditions which would make it advantageous to a seller to substitute monopoly prices for competitive prices. But it can also appear under a market situation which would not bring about monopoly gains. For price discrimination does not enjoin upon the seller the necessity of restricting the amount sold. He does not lose any buyer completely; he must merely take into account that some buyers may restrict the amount of their purchases. But as a rule he has the opportunity to sell the remainder of his supply to people who would not have bought at all or would Edition: current; Page: [389] have bought only smaller quantities if they had had to pay the uniform competitive price.

Consequently the configuration of production costs plays no role in the considerations of the discriminating seller. Production costs are not affected as the total amount produced and sold remains unaltered.

The most common case of price discrimination is that of physicians. A doctor who can perform 80 treatments in a week and charges $3 for each treatment is fully employed by attending to 30 patients and makes $240 a week. If he charges the 10 wealthiest patients, who together consume 50 treatments, $4 instead of $3, they will consume only 40 treatments. The doctor sells the remaining 10 treatments at $2 each to patients who would not have expended $3 for his professional services. Then his weekly proceeds rise to $270.

As price discrimination is practiced by the seller only if it is more advantageous to him than selling at a uniform price, it is obvious that it results in an alteration of consumption and the allocation of factors of production to various employments. The outcome of discrimination is always that the total amount expended for the acquisition of the good concerned increases. The buyers must provide for their excess expenditure by cutting down other purchases. As it is very unlikely that those benefited by price discrimination will spend their gains for the purchase of the same goods as those the other people no longer buy in the same quantity, changes in the market data and in production become unavoidable.

In the above example the 10 wealthiest patients are damaged; they pay $4 for a service for which they used to pay only $3. But it is not only the doctor who derives advantage from the discrimination; the patients whom he charges $2 are benefited too. It is true they must provide the doctor’s fees by renouncing other satisfactions. However, they value these other satisfactions less than that conveyed to them by the doctor’s treatment. Their degree of contentment attained is increased.

For a full comprehension of price discrimination it is well to remember that, under the division of labor, competition among those eager to acquire the same product does not necessarily impair the individual competitor’s position. The competitors’ interests are antagonistic only with regard to the services rendered by the complementary nature-given factors of production. This inescapable natural antagonism is superseded by the advantages derived from the division of labor. As far as average costs of production can be reduced by big-scale production, competition among those eager to acquire the same commodity brings about an improvement in the individual competitor’s Edition: current; Page: [390] situation. The fact that not only a few people but a great number are eager to acquire the commodity c makes it possible to manufacture it in cost-saving processes; then even people with modest means can afford it. In the same way it can sometimes happen that price discrimination renders the satisfaction of a need possible which would have remained unsatisfied in its absence.

There live in a city p lovers of music, each of whom would be prepared to spend $2 for the recital of a virtuoso. But such a concert requires an expenditure greater than 2 p dollars and can therefore not be arranged. But if discrimination of admission fees is possible and among the p friends of music n are ready to spend $4, the recital becomes feasible, provided that the amount 2 (n + p) dollars is sufficient. Then n people spend $4 each and (p − n) people $2 each for the admission and forego the satisfaction of the least urgent need they would have satisfied if they had not preferred to attend the recital. Each person in the audience fares better than he would have if the unfeasibility of price discrimination had prevented the performance. It is to the interest of the organizers to enlarge the audience to the point at which the admission of additional customers involves higher costs than the fees they are ready to spend.

Things would be different if the recital could have been arranged even if no more than $2 was charged for admission. Then price discrimination would have impaired the satisfaction of those who are charged $4.

The most common practices in selling admission tickets for artistic performances and railroad tickets at different rates are not the outcome of price discrimination in the catallactic sense of the term. He who pays a higher rate gets something appreciated more than he who pays less. He gets a better seat, a more comfortable traveling opportunity, and so on. Genuine price discrimination is present in the case of physicians who, although attending to each patient with the same care, charge the wealthier clients more than the less wealthy. It is present in the case of railroads charging more for the shipping of goods the transportation of which adds more to their value than for others although the costs incurred by the railroad are the same. It is obvious that both the doctor and the railroad can practice discrimination only within the limits fixed by the opportunity given to the patient and the shipper to find another solution of their problems that is more to their own advantage. But this refers to one of the two conditions required for the emergence of price discrimination.

It would be idle to point out a state of affairs in which price discrimination could be practiced by all sellers of all kinds of commodities Edition: current; Page: [391] and services. It is more important to establish the fact that within a market economy not sabotaged by government interference the conditions required for price discrimination are so rare that it can fairly be called an exceptional phenomenon.

11: Price Discrimination on the Part of the Buyer

While monopoly prices and monopoly gains cannot be realized to the advantage of a monopolistic buyer, the case is different with price discrimination. There is only one condition required for the emergence of price discrimination on the part of a monopolistic buyer on a free market, namely, crass ignorance of the state of the market on the part of the sellers. As such ignorance is unlikely to last for any length of time, price discrimination can only be practiced if the government interferes.

The Swiss Government has established a government owned and operated trade monopoly for cereals. It buys cereals at world-market prices on foreign markets and at higher prices from domestic farmers. In domestic purchases it pays a higher price to farmers producing at higher costs on the rocky soil of the mountain districts and a lower price—although still higher than the world-market price—to the farmers tilling more fertile land.

12: The Connexity of Prices

If a definite process of production brings about the products p and q simultaneously, the entrepreneurial decisions and actions are directed by weighing the sum of the anticipated prices of p and q. The prices of p and q are particularly connected with one another as changes in the demand for p (or for q) generate changes in the supply of q (or of p). The mutual relation of the prices of p and q can be called connexity of production. The businessman calls p (or q) a by-product of q (or p).

The production of the consumers’ good z requires the employment of the factors p and q, the production of p the employment of the factors a and b, and the production of q the employment of the factors c and d. Then changes in the supply of p (or of q) bring about changes in the demand for q (or for p). It does not matter whether the process of producing z out of p and q is accomplished by the same enterprises which produce p out of a and b and q out of c and d, or by entrepreneurs financially independent of one another, or by the consumers themselves as a preliminary step in their consuming. The prices of p and q are particularly connected with one another because Edition: current; Page: [392]p is useless or of a smaller utility without q and vice versa. The mutual relation of the prices of p and q can be called connexity of consumption.

If the services rendered by a commodity b can be substituted, even though in a not perfectly satisfactory way, for those rendered by another commodity a, a change in the price of one of them affects the price of the other too. The mutual relation of the prices of a and b can be called connexity of substitution.

Connexity of production, connexity of consumption, and connexity of substitution are particular connexities of the prices of a limited number of commodities. From these particular connexities one must distinguish the general connexity of the prices of all goods and services. This general connexity is the outcome of the fact that for every kind of want-satisfaction, besides various more or less specific factors, one scarce factor is required which, in spite of the differences in its qualitative power to produce, can, within the limits precisely defined above,26 be called a nonspecific factor—namely, labor.

Within a hypothetical world in which all factors of production are absolutely specific, human action would operate in a multiplicity of fields of want-satisfaction independent of one another. What links together in our actual world the various fields of want-satisfaction is the existence of a great many nonspecific factors, suitable to be employed for the attainment of various ends and to be substituted in some degree for one another. The fact that one factor, labor, is on the one hand required for every kind of production and on the other hand is, within the limits defined, nonspecific, brings about the general connexity of all human activities. It integrates the pricing process into a whole in which all gears work on one another. It makes the market a concatenation of mutually interdependent phenomena.

It would be absurd to look upon a definite price as if it were an isolated object in itself. A price is expressive of the position which acting men attach to a thing under the present state of their efforts to remove uneasiness. It does not indicate a relationship to something unchanging, but merely the instantaneous position in a kaleidoscopically changing assemblage. In this collection of things considered valuable by the value judgments of acting men each particle’s place is interrelated with those of all other particles. What is called a price is always a relationship within an integrated system which is the composite effect of human relations.

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13: Prices and Income

A market price is a real historical phenomenon, the quantitative ratio at which at a definite place and at a definite date two individuals exchanged definite quantities of two definite goods. It refers to the special conditions of the concrete act of exchange. It is ultimately determined by the value judgments of the individuals involved. It is not derived from the general price structure or from the structure of the prices of a special class of commodities or services. What is called the price structure is an abstract notion derived from a multiplicity of individual concrete prices. The market does not generate prices of land or motorcars in general nor wage rates in general, but prices for a certain piece of land and for a certain car and wage rates for a performance of a certain kind. It does not make any difference for the pricing process to what class the things exchanged are to be assigned from any point of view. However they may differ in other regards, in the very act of exchange they are nothing but commodities, i.e., things valued on account of their power to remove felt uneasiness.

The market does not create or determine incomes. It is not a process of income formation. If the owner of a piece of land and the worker husband the physical resources concerned, the land and the man will renew and preserve their power to render services; the agricultural and urban land for a practically indefinite period, the man for a number of years. If the market situation for these factors of production does not deteriorate, it will be possible in the future too to attain a price for their productive employment. Land and working power can be considered as sources of income if they are dealt with as such, that is, if their capacity to produce is not prematurely exhausted by reckless exploitation. It is provident restraint in the use of factors of production, not their natural and physical properties, which convert them into somewhat durable sources of income. There is in nature no such thing as a stream of income. Income is a category of action; it is the outcome of careful economizing of scarce factors. This is still more obvious in the case of capital goods. The produced factors of production are not permanent. Although some of them may have a life of many years, all of them eventually become useless through wear and tear, sometimes even by the mere passing of time. They become durable sources of income only if their owners treat them as such. Capital can be preserved as a source of income if the consumption of its products, market conditions remaining unchanged, is restricted in such a way as not to impair the replacement of the worn out parts.

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Changes in the market data can frustrate every endeavor to perpetuate a source of income. Industrial equipment becomes obsolete if demand changes or if it is superseded by something better. Land becomes useless if more fertile soil is made accessible in sufficient quantities. Expertness and skill for the performance of special kinds of work lose their remunerativeness when new fashions or new methods of production narrow the opportunity for their employment. The success of any provision for the uncertain future depends on the correctness of the anticipations which guided it. No income can be made safe against changes not adequately foreseen.

Neither is the pricing process a form of distribution. As has been pointed out already, there is nothing in the market economy to which the notion of distribution could be applied.

14: Prices and Production

The pricing process of the unhampered market directs production into those channels in which it best serves the wishes of the consumers as manifested on the market. Only in the case of monopoly prices have the monopolists the power to divert production, within a limited range, from this line into other lines to their own benefit.

The prices determine which of the factors of production should be employed and which should be left unused. The specific factors of production are employed only if there is no more valuable employment available for the complementary nonspecific factors. There are technological recipes, land, and nonconvertible capital goods whose capacity to produce remains unused because their employment would mean a waste of the scarcest of all factors, labor. While under the conditions present in our world there cannot be in the long run unemployment of labor in a free labor market, unused capacity of land and of inconvertible industrial equipment is a regular phenomenon.

It is nonsense to lament the fact of unused capacity. The unused capacity of equipment made obsolete by technological improvement is a landmark of material progress. It would be a blessing if the establishment of durable peace would render munitions plants unused or if the discovery of an efficient method of preventing and curing tuberculosis would render obsolete sanatoria for the treatment of people affected by this evil. It would be sensible to deplore the lack of provision in the past which resulted in malinvestment of capital goods. Yet, men are not infallible. A certain amount of malinvestment is unavoidable. What has to be done is to shun policies that like credit expansion artificially foster malinvestment.

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Modern technology could easily grow oranges and grapes in hothouses in the arctic and subarctic countries. Everybody would call such a venture lunacy. But it is essentially the same to preserve the growing of cereals in rocky mountain valleys by tariffs and other devices of protectionism while elsewhere there is plenty of fallow fertile land. The difference is merely one of degree.

The inhabitants of the Swiss Jura prefer to manufacture watches instead of growing wheat. Watchmaking is for them the cheapest way to acquire wheat. On the other hand the growing of wheat is the cheapest way for the Canadian farmer to acquire watches. The fact that the inhabitants of the Jura do not grow wheat and the Canadians do not manufacture watches is not more worthy of notice than the fact that tailors do not make their shoes and shoemakers do not make their clothes.

15: The Chimera of Nonmarket Prices

Prices are a market phenomenon. They are generated by the market process and are the pith of the market economy. There is no such thing as prices outside the market. Prices cannot be constructed synthetically, as it were. They are the resultant of a certain constellation of market data, of actions and reactions of the members of a market society. It is vain to meditate what prices would have been if some of their determinants had been different. Such fantastic designs are no more sensible than whimsical speculations about what the course of history would have been if Napoleon had been killed in the battle of Arcole or if Lincoln had ordered Major Anderson to withdraw from Fort Sumter.

It is no less vain to ponder on what prices ought to be. Everybody is pleased if the prices of things he wants to buy drop and the prices of the things he wants to sell rise. In expressing such wishes a man is sincere if he admits that his point of view is personal. It is another question whether, from his personal point of view, he would be well advised to prompt the government to use its power of coercion and oppression to interfere with the market’s price structure. It will be shown in the sixth part of this book what the inescapable consequences of such a policy of interventionism must be.

But one deludes oneself or practices deception if one calls such wishes and arbitrary value judgments the voice of objective truth. In human action nothing counts but the various individuals’ desires for the attainment of ends. With regard to the choice of these ends there is no question of truth; all that matters is value. Value judgments are necessarily always subjective, whether they are passed by one man Edition: current; Page: [396] only or by many men, by a blockhead, a professor, or a statesman.

Any price determined on a market is the necessary outgrowth of the interplay of the forces operating, that is, demand and supply. Whatever the market situation which generated this price may be, with regard to it the price is always adequate, genuine, and real. It cannot be higher if no bidder ready to offer a higher price turns up, and it cannot be lower if no seller ready to deliver at a lower price turns up. Only the appearance of such people ready to buy or to sell can alter prices.

Economics analyzes the market process which generates commodity prices, wage rates, and interest rates. It does not develop formulas which would enable anybody to compute a “correct” price different from that established on the market by the interaction of buyers and sellers.

At the bottom of many efforts to determine nonmarket prices is the confused and contradictory notion of real costs. If costs were a real thing, i.e., a quantity independent of personal value judgments and objectively discernible and measurable, it would be possible for a disinterested arbiter to determine their height and thus the correct price. There is no need to dwell any longer on the absurdity of this idea. Costs are a phenomenon of valuation. Costs are the value attached to the most valuable want-satisfaction which remains unsatisfied because the means required for its satisfaction are employed for that want-satisfaction the cost of which we are dealing with. The attainment of an excess of the value of the product over the costs, a profit, is the goal of every production effort. Profit is the pay-off of successful action. It cannot be defined without reference to valuation. It is a phenomenon of valuation and has no direct relation to physical and other phenomena of the external world.

Economic analysis cannot help reducing all items of cost to value judgments. The socialists and interventionists call entrepreneurial profit, interest on capital, and rent of land “unearned” because they consider that only the toil and trouble of the worker is real and worthy of being rewarded. However, reality does not reward toil and trouble. If toil and trouble is expended according to well-conceived plans, its outcome increases the means available for want-satisfaction. Whatever some people may consider as just and fair, the only relevant question is always the same. What alone matters is which system of social organization is better suited to attain those ends for which people are ready to expend toil and trouble. The question is: market economy, or socialism? There is no third solution. The notion of a market economy with nonmarket prices is absurd. The very idea of Edition: current; Page: [397] cost prices is unrealizable. Even if the cost price formula is applied only to entrepreneurial profits, it paralyzes the market. If commodities and services are to be sold below the price the market would have determined for them, supply always lags behind demand. Then the market can neither determine what should or should not be produced, nor to whom the commodities and services should go. Chaos results.

This refers also to monopoly prices. It is reasonable to abstain from all policies which could result in the emergence of monopoly prices. But whether monopoly prices are brought about by such promonopoly government policies or in spite of the absence of such policies, no alleged “fact finding” and no armchair speculation can discover another price at which demand and supply would become equal. The failure of all experiments to find a satisfactory solution for the limited-space monopoly of public utilities clearly proves this truth.

It is the very essence of prices that they are the offshoot of the actions of individuals and groups of individuals acting on their own behalf. The catallactic concept of exchange ratios and prices precludes anything that is the effect of actions of a central authority, of people resorting to violence and threats in the name of society or the state or of an armed pressure group. In declaring that it is not the business of the government to determine prices, we do not step beyond the borders of logical thinking. A government can no more determine prices than a goose can lay hen’s eggs.

We can think of a social system in which there are no prices at all, and we can think of government decrees which aim at fixing prices at a height different from that which the market would determine. It is one of the tasks of economics to study the problems implied. However, precisely because we want to examine these problems it is necessary clearly to distinguish between prices and government decrees. Prices are by definition determined by peoples’ buying and selling or abstention from buying and selling. They must not be confused with fiats issued by governments or other agencies enforcing their orders by an apparatus of coercion and compulsion.27

Edition: current; Page: [398]

CHAPTER 17: Indirect Exchange

1: Media of Exchange and Money

Interpersonal exchange is called indirect exchange if, between the commodities and services the reciprocal exchange of which is the ultimate end of exchanging, one or several media of exchange are interposed. The subject matter of the theory of indirect exchange is the study of the ratios of exchange between the media of exchange on the one hand and the goods and services of all orders on the other hand. The statements of the theory of indirect exchange refer to all instances of indirect exchange and to all things which are employed as media of exchange.

A medium of exchange which is commonly used as such is called money. The notion of money is vague, as its definition refers to the vague term “commonly used.” There are borderline cases in which it cannot be decided whether a medium of exchange is or is not “commonly” used and should be called money. But this vagueness in the denotation of money in no way affects the exactitude and precision required by praxeological theory. For all that is to be predicated of money is valid for every medium of exchange. It is therefore immaterial whether one preserves the traditional term theory of money or substitutes for it another term. The theory of money was and is always the theory of indirect exchange and of the media of exchange.1

2: Observations on Some Widespread Errors

The fateful errors of popular monetary doctrines which have led astray the monetary policies of almost all governments would hardly have come into existence if many economists had not themselves committed blunders in dealing with monetary issues and did not stubbornly cling to them.

There is first of all the spurious idea of the supposed neutrality of money.2 An outgrowth of this doctrine was the notion of the “level” Edition: current; Page: [399] of prices that rises or falls proportionately with the increase or decrease in the quantity of money in circulation. It was not realized that changes in the quantity of money can never affect the prices of all goods and services at the same time and to the same extent. Nor was it realized that changes in the purchasing power of the monetary unit are necessarily linked with changes in the mutual relations between those buying and selling. In order to prove the doctrine that the quantity of money and prices rise and fall proportionately, recourse was had in dealing with the theory of money to a procedure entirely different from that modern economics applies in dealing with all its other problems. Instead of starting from the actions of individuals, as catallactics must do without exception, formulas were constructed designed to comprehend the whole of the market economy. Elements of these formulas were the total supply of money available in the Volkswirtschaft; the volume of trade—i.e., the money equivalent of all transfers of commodities and services as effected in the Volkswirtschaft; the average velocity of circulation of the monetary units; and the level of prices. These formulas seemingly provided evidence of the correctness of the price level doctrine. In fact, however, this whole mode of reasoning is a typical cases of arguing in a circle. For the equation of exchange already involves the level doctrines which it tries to prove. It is essentially nothing but a mathematical expression of the—untenable—doctrine that there is proportionality in the movements of the quantity of money and of prices.

In analyzing the equation of exchange one assumes that one of its elements—total supply of money, volume of trade, velocity of circulation—changes, without asking how such changes occur. It is not recognized that changes in these magnitudes do not emerge in the Volkswirtschaft as such, but in the individual actors’ conditions, and that it is the interplay of the reactions of these actors that results in alterations of the price structure. The mathematical economists refuse to start from the various individuals’ demand for and supply of money. They introduce instead the spurious notion of velocity of circulation fashioned according to the patterns of mechanics.

There is at this point of our reasoning no need to deal with the question of whether or not the mathematical economists are right in assuming that the services rendered by money consist wholly or essentially in its turnover, in its circulation. Even if this were true, it would still be faulty to explain the purchasing power—the price—of the monetary unit on the basis of its services. The services rendered by water, whisky, and coffee do not explain the prices paid for these things. What they explain is only why people, as far as they recognize Edition: current; Page: [400] these services, under certain further conditions demand definite quantities of these things. It is always demand that influences the price structure, not the objective value in use.

It is true that with regard to money the task of catallactics is broader than with regard to vendible goods. It is not the task of catallactics, but of psychology and physiology, to explain why people are intent on securing the services which the various vendible commodities can render. It is a task of catallactics, however, to deal with this question with regard to money. Catallactics alone can tell us what advantages a man expects from holding money. But it is not these expected advantages which determine the purchasing power of money. The eagerness to secure these advantages is only one of the factors in bringing about the demand for money. It is demand, a subjective element whose intensity is entirely determined by value judgments, and not any objective fact, any power to bring about a certain effect, that plays a role in the formation of the market’s exchange ratios.

The deficiency of the equation of exchange and its basic elements is that they look at market phenomena from a holistic point of view. They are deluded by their prepossession with the Volkswirtschaft notion. But where there is, in the strict sense of the term, a Volkswirtschaft, there is neither a market nor prices and money. On a market there are only individuals or groups of individuals acting in concert. What motivate these actors are their own concerns, not those of the whole market economy. If there is any sense in such notions as volume of trade and velocity of circulation, then they refer to the resultant of the individuals’ actions. It is not permissible to resort to these notions in order to explain the actions of the individuals. The first question that catallactics must raise with regard to changes in the total quantity of money available in the market system is how such changes affect the various individuals’ conduct. Modern economics does not ask what “iron” or “bread” is worth, but what a definite piece of iron or of bread is worth to an acting individual at a definite date and a definite place. It cannot help proceeding in the same way with regard to money. The equation of exchange is incompatible with the fundamental principles of economic thought. It is a relapse to the thinking of ages in which people failed to comprehend praxeological phenomena because they were committed to holistic notions. It is sterile, as were the speculations of earlier ages concerning the value of “iron” and “bread” in general.

The theory of money is an essential part of the catallactic theory. Edition: current; Page: [401] It must be dealt with in the same manner which is applied to all other catallactic problems.

3: Demand for Money and Supply of Money

In the marketability of the various commodities and services there prevail considerable differences. There are goods for which it is not difficult to find applicants ready to disburse the highest recompense which, under the given state of affairs, can possibly be obtained, or a recompense only slightly smaller. There are other goods for which it is very hard to find a customer quickly, even if the vendor is ready to be content with a compensation much smaller than he could reap if he could find another aspirant whose demand is more intense. It is these differences in the marketability of the various commodities and services which created indirect exchange. A man who at the instant cannot acquire what he wants to get for the conduct of his own household or business, or who does not yet know what kind of goods he will need in the uncertain future, comes nearer to his ultimate goal if he exchanges a less marketable good he wants to trade against a more marketable one. It may also happen that the physical properties of the merchandise he wants to give away (as, for instance, its perishability or the costs incurred by its storage or similar circumstances) impel him not to wait longer. Sometimes he may be prompted to hurry in giving away the good concerned because he is afraid of a deterioration of its market value. In all such cases he improves his own situation in acquiring a more marketable good, even if this good is not suitable to satisfy directly any of his own needs.

A medium of exchange is a good which people acquire neither for their own consumption nor for employment in their own production activities, but with the intention of exchanging it at a later date against those goods which they want to use either for consumption or for production.

Money is a medium of exchange. It is the most marketable good which people acquire because they want to offer it in later acts of interpersonal exchange. Money is the thing which serves as the generally accepted and commonly used medium of exchange. This is its only function. All the other functions which people ascribe to money are merely particular aspects of its primary and sole function, that of a medium of exchange.3

Media of exchange are economic goods. They are scarce; there is Edition: current; Page: [402] a demand for them. There are on the market people who desire to acquire them and are ready to exchange goods and services against them. Media of exchange have value in exchange. People make sacrifices for their acquisition; they pay “prices” for them. The peculiarity of these prices lies merely in the fact that they cannot be expressed in terms of money. In reference to the vendible goods and services we speak of prices or of money prices. In reference to money we speak of its purchasing power with regard to various vendible goods.

There exists a demand for media of exchange because people want to keep a store of them. Every member of a market society wants to have a definite amount of money in his pocket or box, a cash holding or cash balance of a definite height. Sometimes he wants to keep a larger cash holding, sometimes a smaller; in exceptional cases he may even renounce any cash holding. At any rate, the immense majority of people aim not only to own various vendible goods; they want no less to hold money. Their cash holding is not merely a residuum, an unspent margin of their wealth. It is not an unintentional remainder left over after all intentional acts of buying and selling have been consummated. Its amount is determined by a deliberate demand for cash. And as with all other goods, it is the changes in the relation between demand for and supply of money that bring about changes in the exchange ratio between money and the vendible goods.

Every piece of money is owned by one of the members of the market economy. The transfer of money from the control of one actor into that of another is temporally immediate and continuous. There is no fraction of time in between in which the money is not a part of an individual’s or a firm’s cash holding, but just in “circulation.”4 It is unsound to distinguish between circulating and idle money. It is no less faulty to distinguish between circulating money and hoarded money. What is called hoarding is a height of cash holding which—according to the personal opinion of an observer—exceeds what is deemed normal and adequate. However, hoarding is cash holding. Hoarded money is still money and it serves in the hoards the same purposes which it serves in cash holdings called normal. He who hoards money believes that some special conditions make it expedient to accumulate a cash holding which exceeds the amount he himself would keep under different conditions, or other people keep, or an economist censuring his action considers appropriate. That he acts in this way influences the configuration of the Edition: current; Page: [403] demand for money in the same way in which every “normal” demand influences it.

Many economists avoid applying the terms demand and supply in the sense of demand for and supply of money for cash holding because they fear a confusion with the current terminology as used by the bankers. It is, in fact, customary to call demand for money the demand for short-term loans and supply of money the supply of such loans. Accordingly, one calls the market for short-term loans the money market. One says money is scarce if there prevails a tendency toward a rise in the rate of interest for short-term loans, and one says money is plentiful if the rate of interest for such loans is decreasing. These modes of speech are so firmly entrenched that it is out of the question to venture to discard them. But they have favored the spread of fateful errors. They made people confound the notions of money and of capital and believe that increasing the quantity of money could lower the rate of interest lastingly. But it is precisely the crassness of these errors which makes it unlikely that the terminology suggested could create any misunderstanding. It is hard to assume that economists could err with regard to such fundamental issues.

Others maintained that one should not speak of the demand for and supply of money because the aims of those demanding money differ from the aims of those demanding vendible commodities. Commodities, they say, are demanded ultimately for consumption, while money is demanded in order to be given away in further acts of exchange. This objection is no less invalid. The use which people make of a medium of exchange consists eventually in its being given away. But first of all they are eager to accumulate a certain amount of it in order to be ready for the moment in which a purchase may be accomplished. Precisely because people do not want to provide for their own needs right at the instant at which they give away the goods and services they themselves bring to the market, precisely because they want to wait or are forced to wait until propitious conditions for buying appear, they barter not directly but indirectly through the interposition of a medium of exchange. The fact that money is not worn out by the use one makes of it and that it can render its services practically for an unlimited length of time is an important factor in the configuration of its supply. But it does not alter the fact that the appraisement of money is to be explained in the same way as the appraisement of all other goods: by the demand on the part of those who are eager to acquire a definite quantity of it.

Economists have tried to enumerate the factors which within the Edition: current; Page: [404] whole economic system may increase or decrease the demand for money. Such factors are the population figure; the extent to which the individual households provide for their own needs by autarkic production and the extent to which they produce for other people’s needs, selling their products and buying for their own consumption on the market; the distribution of business activity and the settlement of payments over the various seasons of the year; institutions for the settlement of claims and counterclaims by mutual cancellation, such as clearinghouses. All these factors indeed influence the demand for money and the height of the various individuals’ and firms’ cash holding. But they influence them only indirectly by the role they play in the considerations of people concerning the determination of the amount of cash balances they deem appropriate. What decides the matter is always the value judgments of the men concerned. The various actors make up their minds about what they believe the adequate height of their cash holding should be. They carry out their resolution by renouncing the purchase of commodities, securities, and interest-bearing claims, and by selling such assets or conversely by increasing their purchases. With money, things are not different from what they are with regard to all other goods and services. The demand for money is determined by the conduct of people intent upon acquiring it for their cash holding.

Another objection raised against the notion of the demand for money was this: The marginal utility of the money unit decreases much more slowly than that of the other commodities; in fact its decrease is so slow that it can be practically ignored. With regard to money nobody ever says that his demand is satisfied, and nobody ever forsakes an opportunity to acquire more money provided the sacrifice required is not too great. It is therefore impermissible to consider the demand for money as limited. The very notion of an unlimited demand is, however, contradictory. This popular reasoning is entirely fallacious. It confounds the demand for money for cash holding with the desire for more wealth as expressed in terms of money. He who says that his thirst for more money can never be quenched, does not mean to say that his cash holding can never be too large. What he really means is that he can never be rich enough. If additional money flows into his hands, he will not use it for an increase of his cash balance or he will use only a part of it for this purpose. He will expend the surplus either for instantaneous consumption or for investment. Nobody ever keeps more money than he wants to have as cash holding.

The insight that the exchange ratio between money on the one hand and the vendible commodities and services on the other is determined, in the same way as the mutual exchange ratios between the various vendible goods, by demand and supply was the essence of the quantity theory of money.Edition: current; Page: [405] This theory is essentially an application of the general theory of supply and demand to the special instance of money. Its merit was the endeavor to explain the determination of money’s purchasing power by resorting to the same reasoning which is employed for the explanation of all other exchange ratios. Its shortcoming was that it resorted to a holistic interpretation. It looked at the total supply of money in the Volkswirtschaft and not at the actions of the individual men and firms. An outgrowth of this erroneous point of view was the idea that there prevails a proportionality in the changes of the—total—quantity of money and of money prices. But the older critics failed in their attempts to explode the errors inherent in the quantity theory and to substitute a more satisfactory theory for it. They did not fight what was wrong in the quantity theory; they attacked, on the contrary, its nucleus of truth. They were intent upon denying that there is a causal relation between the movements of prices and those of the quantity of money. This denial led them into a labyrinth of errors, contradictions, and nonsense. Modern monetary theory takes up the thread of the traditional quantity theory as far as it starts from the cognition that changes in the purchasing power of money must be dealt with according to the principles applied to all other market phenomena and that there exists a connection between the changes in the demand for and supply of money on the one hand and those of purchasing power on the other. In this sense one may call the modern theory of money an improved variety of the quantity theory.

The Epistemological Import of Carl Menger’s Theory of the Origin of Money

Carl Menger has not only provided an irrefutable praxeological theory of the origin of money. He has also recognized the import of his theory for the elucidation of fundamental principles of praxeology and its methods of research.5

There were authors who tried to explain the origin of money by decree or covenant. The authority, the state, or a compact between citizens has purposively and consciously established indirect exchange and money. The main deficiency of this doctrine is not to be seen in the assumption that people of an age unfamiliar with indirect Edition: current; Page: [406] exchange and money could design a plan of a new economic order, entirely different from the real conditions of their own age, and could comprehend the importance of such a plan. Neither is it to be seen in the fact that history does not afford a clue for the support of such statements. There are more substantial reasons for rejecting it.

If it is assumed that the conditions of the parties concerned are improved by every step that leads from direct exchange to indirect exchange and subsequently to giving preference for use as a medium of exchange to certain goods distinguished by their especially high marketability, it is difficult to conceive why one should, in dealing with the origin of indirect exchange, resort in addition to authoritarian decree or an explicit compact between citizens. A man who finds it hard to obtain in direct barter what he wants to acquire renders better his chances of acquiring it in later acts of exchange by the procurement of a more marketable good. Under these circumstances there was no need of government interference or of a compact between the citizens. The happy idea of proceeding in this way could strike the shrewdest individuals, and the less resourceful could imitate the former’s method. It is certainly more plausible to take for granted that the immediate advantages conferred by indirect exchange were recognized by the acting parties than to assume that the whole image of a society trading by means of money was conceived by a genius and, if we adopt the covenant doctrine, made obvious to the rest of the people by persuasion.

If, however, we do not assume that individuals discovered the fact that they fare better through indirect exchange than through waiting for an opportunity for direct exchange, and, for the sake of argument, admit that the authorities or a compact introduced money, further questions are raised. We must ask what kind of measures were applied in order to induce people to adopt a procedure the utility of which they did not comprehend and which was technically more complicated than direct exchange. We may assume that compulsion was practiced. But then we must ask, further, at what time and by what occurrences indirect exchange and the use of money later ceased to be procedures troublesome or at least indifferent to the individuals concerned and became advantageous to them.

The praxeological method traces all phenomena back to the actions of individuals. If conditions of interpersonal exchange are such that indirect exchange facilitates the transactions, and if and as far as people realize these advantages, indirect exchange and money come into being. Historical experience shows that these conditions were and are present. How, in the absence of these conditions, people could have adopted indirect exchange and money and clung to these modes of exchanging is inconceivable.

The historical question concerning the origin of indirect exchange Edition: current; Page: [407] and money is after all of no concern to praxeology. The only relevant thing is that indirect exchange and money exist because the conditions for their existence were and are present. If this is so, praxeology does not need to resort to the hypothesis that authoritarian decree or a covenant invented these modes of exchanging. The étatists may if they like continue to ascribe the “invention” of money to the state, however unlikely this may be. What matters is that a man acquires a good not in order to consume it or to use it in production, but in order to give it away in a further act of exchange. Such conduct on the part of people makes a good a medium of exchange and, if such conduct becomes common with regard to a certain good, makes it money. All theorems of the catallactic theory of media of exchange and of money refer to the services which a good renders in its capacity as a medium of exchange. Even if it were true that the impulse for the introduction of indirect exchange and money was provided by the authorities or by an agreement between the members of society, the statement remains unshaken that only the conduct of exchanging people can create indirect exchange and money.

History may tell us where and when for the first time media of exchange came into use and how, subsequently, the range of goods employed for this purpose was more and more restricted. As the differentiation between the broader notion of a medium of exchange and the narrower notion of money is not sharp, but gradual, no agreement can be reached about the historical transition from simple media of exchange to money. Answering such a question is a matter of historical understanding. But, as has been mentioned, the distinction between direct exchange and indirect exchange is sharp and everything that catallactics establishes with regard to media of exchange refers categorially to all goods which are demanded and acquired as such media.

As far as the statement that indirect exchange and money were established by decree or by covenant is meant to be an account of historical events, it is the task of historians to expose its falsity. As far as it is advanced merely as a historical statement, it can in no way affect the catallactic theory of money and its explanation of the evolution of indirect exchange. But if it is designed as a statement about human action and social events, it is useless because it states nothing about action. It is not a statement about human action to declare that one day rulers or citizens assembled in convention were suddenly struck by the inspiration that it would be a good idea to exchange indirectly and through the intermediary of a commonly used medium of exchange. It is merely pushing back the problem involved.

It is necessary to comprehend that one does not contribute anything to the scientific conception of human actions and social phenomena if one declares that the state or a charismatic leader or an inspiration Edition: current; Page: [408] which descended upon all the people have created them. Neither do such statements refute the teachings of a theory showing how such phenomena can be acknowledged as “the unintentional outcome, the resultant not deliberately designed and aimed at by specifically individual endeavors of the members of a society.”6

4: The Determination of the Purchasing Power of Money

As soon as an economic good is demanded not only by those who want to use it for consumption or production, but also by people who want to keep it as a medium of exchange and to give it away at need in a later act of exchange, the demand for it increases. A new employment for this good has emerged and creates an additional demand for it. As with every other economic good, such an additional demand brings about a rise in its value in exchange, i.e., in the quantity of other goods which are offered for its acquisition. The amount of other goods which can be obtained in giving away a medium of exchange, its “price” as expressed in terms of various goods and services, is in part determined by the demand of those who want to acquire it as a medium of exchange. If people stop using the good in question as a medium of exchange, this additional specific demand disappears and the “price” drops concomitantly.

Thus the demand for a medium of exchange is the composite of two partial demands: the demand displayed by the intention to use it in consumption and production and that displayed by the intention to use it as a medium of exchange.7 With regard to modern metallic money one speaks of the industrial demand and of the monetary demand. The value in exchange (purchasing power) of a medium of exchange is the resultant of the cumulative effect of both partial demands.

Now the extent of that part of the demand for a medium of exchange which is displayed on account of its service as a medium of exchange depends on its value in exchange. This fact raises difficulties which many economists considered insoluble so that they abstained from following farther along this line of reasoning. It is illogical, they said, to explain the purchasing power of money by reference to the demand for money, and the demand for money by reference to its purchasing power.

The difficulty is, however, merely apparent. The purchasing power Edition: current; Page: [409] which we explain by referring to the extent of specific demand is not the same purchasing power the height of which determines this specific demand. The problem is to conceive the determination of the purchasing power of the immediate future, of the impending moment. For the solution of this problem we refer to the purchasing power of the immediate past, of the moment just passed. These are two distinct magnitudes. It is erroneous to object to our theorem, which may be called the regression theorem, that it moves in a vicious circle.8

But, say the critics, this is tantamount to merely pushing back the problem. For now one must still explain the determination of yesterday’s purchasing power. If one explains this in the same way by referring to the purchasing power of the day before yesterday and so on, one slips into a regressus in infinitum [(Latin) process of going back endlessly]. This reasoning, they assert, is certainly not a complete and logically satisfactory solution of the problem involved. What these critics fail to see is that the regression does not go back endlessly. It reaches a point at which the explanation is completed and no further question remains unanswered. If we trace the purchasing power of money back step by step, we finally arrive at the point at which the service of the good concerned as a medium of exchange begins. At this point yesterday’s exchange value is exclusively determined by the nonmonetary—industrial—demand which is displayed only by those who want to use this good for other employments than that of a medium of exchange.

But, the critics continue, this means explaining that part of money’s purchasing power which is due to its service as a medium of exchange by its employment for industrial purposes. The very problem, the explanation of the specific monetary component of its exchange value, remains unsolved. Here too the critics are mistaken. That component of money’s value which is an outcome of the services it renders as a medium of exchange is entirely explained by reference to these specific monetary services and the demand they create. Two facts are not to be denied and are not denied by anybody. First, that the demand for a medium of exchange is determined by considerations Edition: current; Page: [410] of its exchange value which is an outcome both of the monetary and the industrial services it renders. Second, that the exchange value of a good which has not yet been demanded for service as a medium of exchange is determined solely by a demand on the part of people eager to use it for industrial purposes, i.e., either for consumption or for production. Now, the regression theorem aims at interpreting the first emergence of a monetary demand for a good which previously had been demanded exclusively for industrial purposes as influenced by the exchange value that was ascribed to it at this moment on account of its nonmonetary services only. This certainly does not involve explaining the specific monetary exchange value of a medium of exchange on the ground of its industrial exchange value.

Finally it was objected to the regression theorem that its approach is historical, not theoretical. This objection is no less mistaken. To explain an event historically means to show how it was produced by forces and factors operating at a definite date and a definite place. These individual forces and factors are the ultimate elements of the interpretation. They are ultimate data and as such not open to any further analysis and reduction. To explain a phenomenon theoretically means to trace back its appearance to the operation of general rules which are already comprised in the theoretical system. The regression theorem complies with this requirement. It traces the specific exchange value of a medium of exchange back to its function as such a medium and to the theorems concerning the process of valuing and pricing as developed by the general catallactic theory. It deduces a more special case from the rules of a more universal theory. It shows how the special phenomenon necessarily emerges out of the operation of the rules generally valid for all phenomena. It does not say: This happened at that time and at that place. It says: This always happens when the conditions appear; whenever a good which has not been demanded previously for the employment as a medium of exchange begins to be demanded for this employment, the same effects must appear again; no good can be employed for the function of a medium of exchange which at the very beginning of its use for this purpose did not have exchange value on account of other employments. And all these statements implied in the regression theorem are enounced apodictically as implied in the apriorism of praxeology. It must happen this way. Nobody can ever succeed in constructing a hypothetical case in which things were to occur in a different way.

The purchasing power of money is determined by demand and supply, as is the case with the prices of all vendible goods and services. As action always aims at a more satisfactory arrangement of future Edition: current; Page: [411] conditions, he who considers acquiring or giving away money is, of course, first of all interested in its future purchasing power and the future structure of prices. But he cannot form a judgment about the future purchasing power of money otherwise than by looking at its configuration in the immediate past. It is this fact that radically distinguishes the determination of the purchasing power of money from the determination of the mutual exchange ratios between the various vendible goods and services. With regard to these latter the actors have nothing else to consider than their importance for future want-satisfaction. If a new commodity unheard of before is offered for sale, as was, for instance, the case with radio sets a few decades ago, the only question that matters for the individual is whether or not the satisfaction that the new gadget will provide is greater than that expected from those goods he would have to renounce in order to buy the new thing. Knowledge about past prices is for the buyer merely a means to reap a consumer’s surplus. If he were not intent upon this goal, he could, if need be, arrange his purchases without any familiarity with the market prices of the immediate past, which are popularly called present prices. He could make value judgments without appraisement. As has been mentioned already, the obliteration of the memory of all prices of the past would not prevent the formation of new exchange ratios between the various vendible things. But if knowledge about money’s purchasing power were to fade away, the process of developing indirect exchange and media of exchange would have to start anew. It would become necessary to begin again with employing some goods, more marketable than the rest, as media of exchange. The demand for these goods would increase and would add to the amount of exchange value derived from their industrial (nonmonetary) employment a specific component due to their new use as a medium of exchange. A value judgment is, with reference to money, only possible if it can be based on appraisement. The acceptance of a new kind of money presupposes that the thing in question already has previous exchange value on account of the services it can render directly to consumption or production. Neither a buyer nor a seller could judge the value of a monetary unit if he had no information about its exchange value—its purchasing power—in the immediate past.

The relation between the demand for money and the supply of money, which may be called the money relation, determines the height of purchasing power. Today’s money relation, as it is shaped on the ground of yesterday’s purchasing power, determines today’s purchasing power. He who wants to increase his cash holding restricts Edition: current; Page: [412] his purchases and increases his sales and thus brings about a tendency toward falling prices. He who wants to reduce his cash holding increases his purchases—either for consumption or for production and investment—and restricts his sales; thus he brings about a tendency toward rising prices.

Changes in the supply of money must necessarily alter the disposition of vendible goods as owned by various individuals and firms. The quantity of money available in the whole market system cannot increase or decrease otherwise than by first increasing or decreasing the cash holdings of certain individual members. We may, if we like, assume that every member gets a share of the additional money right at the moment of its inflow into the system, or shares in the reduction of the quantity of money. But whether we assume this or not, the final result of our demonstration will remain the same. This result will be that changes in the structure of prices brought about by changes in the supply of money available in the economic system never affect the prices of the various commodities and services to the same extent and at the same date.

Let us assume that the government issues an additional quantity of paper money. The government plans either to buy commodities and services or to repay debts incurred or to pay interest on such debts. However this may be, the treasury enters the market with an additional demand for goods and services; it is now in a position to buy more goods than it could buy before. The prices of the commodities it buys rise. If the government had expended in its purchases money collected by taxation, the taxpayers would have restricted their purchases and, while the prices of goods bought by the government would have risen, those of other goods would have dropped. But this fall in the prices of the goods the taxpayers used to buy does not occur if the government increases the quantity of money at its disposal without reducing the quantity of money in the hands of the public. The prices of some commodities—viz., of those the government buys—rise immediately, while those of the other commodities remain unaltered for the time being. But the process goes on. Those selling the commodities asked for by the government are now themselves in a position to buy more than they used previously. The prices of the things these people are buying in larger quantities therefore rise too. Thus the boom spreads from one group of commodities and services to other groups until all prices and wage rates have risen. The rise in prices is thus not synchronous for the various commodities and services.

When eventually, in the further course of the increase in the quantity Edition: current; Page: [413] of money, all prices have risen, the rise does not affect the various commodities and services to the same extent. For the process has affected the material position of various individuals to different degrees. While the process is under way, some people enjoy the benefit of higher prices for the goods or services they sell, while the prices of the things they buy have not yet risen or have not risen to the same extent. On the other hand, there are people who are in the unhappy situation of selling commodities and services whose prices have not yet risen or not in the same degree as the prices of the goods they must buy for their daily consumption. For the former the progressive rise in prices is a boon, for the latter a calamity. Besides, the debtors are favored at the expense of the creditors. When the process once comes to an end, the wealth of various individuals has been affected in different ways and to different degrees. Some are enriched, some impoverished. Conditions are no longer what they were before. The new order of things results in changes in the intensity of demand for various goods. The mutual ratio of the money prices of the vendible goods and services is no longer the same as before. The price structure has changed apart from the fact that all prices in terms of money have risen. The final prices to the establishment of which the market tends after the effects of the increase in the quantity of money have been fully consummated are not equal to the previous final prices multiplied by the same multiplier.

The main fault of the old quantity theory as well as the mathematical economists’ equation of exchange is that they have ignored this fundamental issue. Changes in the supply of money must bring about changes in other data too. The market system before and after the inflow or outflow of a quantity of money is not merely changed in that the cash holdings of the individuals and prices have increased or decreased. There have been effected also changes in the reciprocal exchange ratios between the various commodities and services which, if one wants to resort to metaphors, are more adequately described by the image of price revolution than by the misleading figure of an elevation or a sinking of the “price level.”

We may at this point disregard the effects brought about by the influence on the content of all deferred payments as stipulated by contracts. We will deal later with them and with the operation of monetary events on consumption and production, investment in capital goods, and accumulation and consumption of capital. But even in setting aside all these things, we must never forget that changes in the quantity of money affect prices in an uneven way. It depends on the data of each particular case at what moment and to what Edition: current; Page: [414] extent the prices of the various commodities and services are affected. In the course of a monetary expansion (inflation) the first reaction is not only that the prices of some of them rise more quickly and more steeply than others. It may also occur that some fall at first as they are for the most part demanded by those groups whose interests are hurt.

Changes in the money relation are not only caused by governments issuing additional paper money. An increase in the production of the precious metals employed as money has the same effects although, of course, other classes of the population may be favored or hurt by it. Prices also rise in the same way if, without a corresponding reduction in the quantity of money available, the demand for money falls because of a general tendency toward a diminution of cash holdings. The money expended additionally by such a “dishoarding” brings about a tendency toward higher prices in the same way as that flowing from the gold mines or from the printing press. Conversely, prices drop when the supply of money falls (e.g., through a withdrawal of paper money) or the demand for money increases (e.g., through a tendency toward “hoarding,” the keeping of greater cash balances). The process is always uneven and by steps, disproportionate and asymmetrical.

It could be and has been objected that the normal production of the gold mines brought to the market may well entail an increase in the quantity of money, but does not increase the income, still less the wealth, of the owners of the mines. These people earn only their “normal” income and thus their spending of it cannot disarrange market conditions and the prevailing tendencies toward the establishment of final prices and the equilibrium of the evenly rotating economy. For them, the annual output of the mines does not mean an increase in riches and does not impel them to offer higher prices. They will continue to live at the standard at which they used to live before. Their spending within these limits will not revolutionize the market. Thus the normal amount of gold production, although certainly increasing the quantity of money available, cannot put into motion the process of depreciation. It is neutral with regard to prices.

As against this reasoning one must first of all observe that within a progressing economy in which population figures are increasing and the division of labor and its corollary, industrial specialization, are perfected, there prevails a tendency toward an increase in the demand for money. Additional people appear on the scene and want to establish cash holdings. The extent of economic self-sufficiency, i.e., of production for the household’s own needs, shrinks and people become more dependent upon the market; this will, by and large, Edition: current; Page: [415] impel them to increase their holding of cash. Thus the price-raising tendency emanating from what is called the “normal” gold production encounters a price-cutting tendency emanating from the increased demand for cash holding. However, these two opposite tendencies do not neutralize each other. Both processes take their own course, both result in a disarrangement of existing social conditions, making some people richer, some people poorer. Both affect the prices of various goods at different dates and to a different degree. It is true that the rise in the prices of some commodities caused by one of these processes can finally be compensated by the fall caused by the other process. It may happen that at the end some or many prices come back to their previous height. But this final result is not the outcome of an absence of movements provoked by changes in the money relation. It is rather the outcome of the joint effect of the coincidence of two processes independent of each other, each of which brings about alterations in the market data as well as in the material conditions of various individuals and groups of individuals. The new structure of prices may not differ very much from the previous one. But it is the resultant of two series of changes which have accomplished all inherent social transformations.

The fact that the owners of gold mines rely upon steady yearly proceeds from their gold production does not cancel the newly mined gold’s impression upon prices. The owners of the mines take from the market, in exchange for the gold produced, the goods and services required for their mining and the goods needed for their consumption and their investments in other lines of production. If they had not produced this amount of gold, prices would not have been affected by it. It is beside the point that they have anticipated the future yield of the mines and capitalized it and that they have adjusted their standard of living to the expectation of steady proceeds from the mining operations. The effects which the newly mined gold exercises on their expenditure and on that of those people whose cash holdings it enters later step by step begin only at the instant this gold is available in the hands of the mine owners. If, in the expectation of future yields, they had expended money at an earlier date and the expected yield failed to appear, conditions would not differ from other cases in which consumption was financed by credit based on expectations not realized by later events.

Changes in the extent of the desired cash holding of various people neutralize one another only to the extent that they are regularly recurring and mutually connected by a causal reciprocity. Salaried people and wage earners are not paid daily, but at certain pay days Edition: current; Page: [416] for a period of one or several weeks. They do not plan to keep their cash holding within the period between pay days at the same level; the amount of cash in their pockets declines with the approach of the next pay day. On the other hand, the merchants who supply them with the necessities of life increase their cash holdings concomitantly. The two movements condition each other; there is a causal interdependence between them which harmonizes them both with regard to time and to quantitative amount. Neither the dealer nor his customer lets himself be influenced by these recurrent fluctuations. Their plans concerning cash holding as well as their business operations and their spending for consumption respectively have the whole period in view and take it into account as a whole.

It was this phenomenon that led economists to the image of a regular circulation of money and to the neglect of the changes in the individuals’ cash holdings. However, we are faced with a concatenation which is limited to a narrow, neatly circumscribed field. Only as far as the increase in the cash holding of one group of people is temporally and quantitatively related to the decrease in the cash holding of another group and as far as these changes are self-liquidating within the course of a period which the members of both groups consider as a whole in planning their cash holding, can the neutralization take place. Beyond this field there is no question of such a neutralization.

5: The Problem of Hume and Mill and the Driving Force of Money

Is it possible to think of a state of affairs in which changes in the purchasing power of money occur at the same time and to the same extent with regard to all commodities and services and in proportion to the changes effected in either the demand for or the supply of money? In other words, is it possible to think of neutral money within the frame of an economic system which does not correspond to the imaginary construction of an evenly rotating economy? We may call this pertinent question the problem of Hume and Mill.

It is uncontested that neither Hume nor Mill succeeded in finding a positive answer to this question.9 Is it possible to answer it categorically in the negative?

We imagine two systems of an evenly rotating economy A and B. The two systems are independent and in no way connected with one another. The two systems differ from one another only in the fact Edition: current; Page: [417] that to each amount of money m in A there corresponds an amount n m in B, n being greater or smaller than 1; we assume that there are no deferred payments and that the money used in both systems serves only monetary purposes and does not allow of any nonmonetary use. Consequently the prices in the two systems are in the ratio 1:n. Is it thinkable that conditions in A can be altered at one stroke in such a way as to make them entirely equivalent to conditions in B?

The answer to this question must obviously be in the negative. He who wants to answer it in the positive must assume that a deus ex machina [(Latin) providential, god-like, intervention] approaches every individual at the same instant, increases or decreases his cash holding by multiplying it by n, and tells him that henceforth he must multiply by n all price data which he employs in his appraisements and calculations. This cannot happen without a miracle.

It has been pointed out already that in the imaginary construction of an evenly rotating economy the very notion of money vanishes into an unsubstantial calculation process, self-contradictory and devoid of any meaning.10 It is impossible to assign any function to indirect exchange, media of exchange, and money within an imaginary construction the characteristic mark of which is unchangeability and rigidity of conditions.

Where there is no uncertainty concerning the future, there is no need for any cash holding. As money must necessarily be kept by people in their cash holdings, there cannot be any money. The use of media of exchange and the keeping of cash holdings are conditioned by the changeability of economic data. Money in itself is an element of change; its existence is incompatible with the idea of a regular flow of events in an evenly rotating economy.

Every change in the money relation alters—apart from its effects upon deferred payments—the conditions of the individual members of society. Some become richer, some poorer. It may happen that the effects of a change in the demand for and supply of money encounter the effects of opposite changes occurring by and large at the same time and to the same extent; it may happen that the resultant of the two opposite movements is such that no conspicuous changes in the price structure emerge. But even then the effects on the conditions of the various individuals are not absent. Each change in the money relation takes its own course and produces its own particular effects. If an inflationary movement and a deflationary one occur at the same time or if an inflation is temporally followed by a deflation in such a Edition: current; Page: [418] way that prices finally are not very much changed, the social consequences of each of the two movements do not cancel each other. To the social consequences of an inflation those of a deflation are added. There is no reason to assume that all or even most of those favored by one movement will be hurt by the second one, or vice versa.

Money is neither an abstract numéraire nor a standard of value or prices. It is necessarily an economic good and as such it is valued and appraised on its own merits, i.e., the services which a man expects from holding cash. On the market there is always change and movement. Only because there are fluctuations is there money. Money is an element of change not because it “circulates,” but because it is kept in cash holdings. Only because people expect changes about the kind and extent of which they have no certain knowledge whatsoever, do they keep money.

While money can be thought of only in a changing economy, it is in itself an element of further changes. Every change in the economic data sets it in motion and makes it the driving force of new changes. Every shift in the mutual relation of the exchange ratios between the various nonmonetary goods not only brings about changes in production and in what is popularly called distribution, but also provokes changes in the money relation and thus further changes. Nothing can happen in the orbit of vendible goods without affecting the orbit of money, and all that happens in the orbit of money affects the orbit of commodities.

The notion of a neutral money is no less contradictory than that of a money of stable purchasing power. Money without a driving force of its own would not, as people assume, be a perfect money; it would not be money at all.

It is a popular fallacy to believe that perfect money should be neutral and endowed with unchanging purchasing power, and that the goal of monetary policy should be to realize this perfect money. It is easy to understand this idea as a reaction against the still more popular postulates of the inflationists. But it is an excessive reaction, it is in itself confused and contradictory, and it has worked havoc because it was strengthened by an inveterate error inherent in the thought of many philosophers and economists.

These thinkers are misled by the widespread belief that a state of rest is more perfect than one of movement. Their idea of perfection implies that no more perfect state can be thought of and consequently that every change would impair it. The best that can be said of a motion is that it is directed toward the attainment of a state of perfection in which there is rest because every further movement would Edition: current; Page: [419] lead into a less perfect state. Motion is seen as the absence of equilibrium and full satisfaction, as a manifestation of trouble and want. As far as such thoughts merely establish the fact that action aims at the removal of uneasiness and ultimately at the attainment of full satisfaction, they are well founded. But one must not forget that rest and equilibrium are not only present in a state in which perfect contentment has made people perfectly happy, but no less in a state in which, although wanting in many regards, they do not see any means of improving their condition. The absence of action is not only the result of full satisfaction; it can no less be the corollary of the inability to render things more satisfactory. It can mean hopelessness as well as contentment.

With the real universe of action and unceasing change, with the economic system which cannot be rigid, neither neutrality of money nor stability of its purchasing power are compatible. A world of the kind which the necessary requirements of neutral and stable money presuppose would be a world without action.

It is therefore neither strange nor vicious that in the frame of such a changing world money is neither neutral nor stable in purchasing power. All plans to render money neutral and stable are contradictory. Money is an element of action and consequently of change. Changes in the money relation, i.e., in the relation of the demand for and the supply of money, affect the exchange ratio between money on the one hand and the vendible commodities on the other hand. These changes do not affect at the same time and to the same extent the prices of the various commodities and services. They consequently affect the wealth of the various members of society in a different way.

6: Cash-Induced and Goods-Induced Changes in Purchasing Power

Changes in the purchasing power of money, i.e., in the exchange ratio between money and the vendible goods and commodities, can originate either from the side of money or from the side of the vendible goods and commodities. The change in the data which provokes them can either occur in the demand for and supply of money or in the demand for and supply of the other goods and services. We may accordingly distinguish between cash-induced and goods-induced changes in purchasing power.

Goods-induced changes in purchasing power can be brought about by changes in the supply of commodities and services or in the demand for individual commodities and services. A general rise or fall Edition: current; Page: [420] in the demand for all goods and services or the greater part of them can be effected only from the side of money.

Let us now scrutinize the social and economic consequences of changes in the purchasing power of money under the following three assumptions: first, that the money in question can only be used as money—i.e., as a medium of exchange—and can serve no other purpose; second, that there is only exchange of present goods and no exchange of present goods against future goods; third, that we disregard the effects of changes in purchasing power on monetary calculation.

Under these assumptions all that cash-induced changes in purchasing power bring about are shifts in the disposition of wealth among different individuals. Some get richer, others poorer; some are better supplied, others less; what some people gain is paid for by the loss of others. It would, however, be impermissible to interpret this fact by saying that total satisfaction remained unchanged or that, while no changes have occurred in total supply, the state of total satisfaction or of the sum of happiness has been increased or decreased by changes in the distribution of wealth. The notions of total satisfaction or total happiness are empty. It is impossible to discover a standard for comparing the different degrees of satisfaction or happiness attained by various individuals.

Cash-induced changes in purchasing power indirectly generate further changes by favoring either the accumulation of additional capital or the consumption of capital available. Whether and in what direction such secondary effects are brought about depends on the specific data of each case. We shall deal with these important problems at a later point.11

Goods-induced changes in purchasing power are sometimes nothing else but consequences of a shift of demand from some goods to others. If they are brought about by an increase or a decrease in the supply of goods they are not merely transfers from some people to other people. They do not mean that Peter gains what Paul has lost. Some people may become richer although nobody is impoverished, and vice versa.

We may describe this fact in the following way: Let A and B be two independent systems which are in no way connected with each other. In both systems the same kind of money is used, a money which cannot be used for any nonmonetary purpose. Now we assume, as case 1, that A and B differ from each other only in so far as in B the Edition: current; Page: [421] total supply of money is n m, m being the total supply of money in A, and that to every cash holding of c and to every claim in terms of money d in A there corresponds a cash holding of n c and a claim of n d in B. Inevery other respect A equals B. Then we assume, as case 2, that A and B differ from each other only in so far as in B the total supply of a certain commodity r is n p, p being the total supply of this commodity in A, and that to every stock v of this commodity r in A there corresponds a stock of n v in B. In both cases n is greater than 1. If we ask every individual of A whether he is ready to make the slightest sacrifice in order to exchange his position for the corresponding place in B, the answer will be unanimously in the negative in case 1. But in case 2 all owners of r and all those who do not own any r, but are eager to acquire a quantity of it—i.e., at least one individual—will answer in the affirmative.

The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power. As the operation of the market tends to determine the final state of money’s purchasing power at a height at which the supply of and the demand for money coincide, there can never be an excess or a deficiency of money. Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money, no matter whether the total quantity of money is great or small. Changes in money’s purchasing power generate changes in the disposition of wealth among the various members of society. From the point of view of people eager to be enriched by such changes, the supply of money may be called insufficient or excessive, and the appetite for such gains may result in policies designed to bring about cash-induced alterations in purchasing power. However, the services which money renders can be neither improved nor repaired by changing the supply of money. There may appear an excess or a deficiency of money in an individual’s cash holding. But such a condition can be remedied by increasing or decreasing consumption or investment. (Of course, one must not fall prey to the popular confusion between the demand for money for cash holding and the appetite for more wealth.) The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.

From the point of view of this insight one may call wasteful all expenditures incurred for increasing the quantity of money. The fact that things which could render some other useful services are Edition: current; Page: [422] employed as money and thus withheld from these other employments appears as a superfluous curtailment of limited opportunities for want-satisfaction. It was this idea that led Adam Smith and Ricardo to the opinion that it was very beneficial to reduce the cost of producing money by resorting to the use of paper printed currency. However, things appear in a different light to the students of monetary history. If one looks at the catastrophic consequences of the great paper money inflations, one must admit that the expensiveness of gold production is the minor evil. It would be futile to retort that these catastrophes were brought about by the improper use which the governments made of the powers that credit money and fiat money placed in their hands and that wiser governments would have adopted sounder policies. As money can never be neutral and stable in purchasing power, a government’s plans concerning the determination of the quantity of money can never be impartial and fair to all members of society. Whatever a government does in the pursuit of aims to influence the height of purchasing power depends necessarily upon the rulers’ personal value judgments. It always furthers the interests of some groups of people at the expense of other groups. It never serves what is called the commonweal or the public welfare. In the field of monetary policies too there is no such thing as a scientific ought.

The choice of the good to be employed as a medium of exchange and as money is never indifferent. It determines the course of the cash-induced changes in purchasing power. The question is only who should make the choice: the people buying and selling on the market, or the government? It was the market which in a selective process, going on for ages, finally assigned to the precious metals gold and silver the character of money. For two hundred years the governments have interfered with the market’s choice of the money medium. Even the most bigoted étatists do not venture to assert that this interference has proved beneficial.

Inflation and Deflation; Inflationism and Deflationism

The notions of inflation and deflation are not praxeological concepts. They were not created by economists, but by the mundane speech of the public and of politicians. They implied the popular fallacy that there is such a thing as neutral money or money of stable purchasing power and that sound money should be neutral and stable in purchasing power. From this point of view the term inflation was applied to signify cash-induced changes resulting in a drop in purchasing power, and the term deflation to signify cash-induced changes resulting in a rise in purchasing power.

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However, those applying these terms are not aware of the fact that purchasing power never remains unchanged and that consequently there is always either inflation or deflation. They ignore these necessarily perpetual fluctuations as far as they are only small and inconspicuous, and reserve the use of the terms to big changes in purchasing power. Since the question at what point a change in purchasing power begins to deserve being called big depends on personal relevance judgments, it becomes manifest that inflation and deflation are terms lacking the categorial precision required for praxeological, economic, and catallactic concepts. Their application is appropriate for history and politics. Catallactics is free to resort to them only when applying its theorems to the interpretation of events of economic history and of political programs. Moreover, it is very expedient even in rigid catallactic disquisitions to make use of these two terms whenever no misinterpretation can possibly result and pedantic heaviness of expression can be avoided. But it is necessary never to forget that all that catallactics says with regard to inflation and deflation—i.e., big cash-induced changes in purchasing power—is valid also with regard to small changes, although, of course, the consequences of smaller changes are less conspicuous than those of big changes.

The terms inflationism and deflationism, inflationist and deflationist, signify the political programs aiming at inflation and deflation in the sense of big cash-induced changes in purchasing power.

The semantic revolution which is one of the characteristic features of our day has also changed the traditional connotation of the terms inflation and deflation. What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates. This innovation is by no means harmless. It plays an important role in fomenting the popular tendencies toward inflationism.

First of all there is no longer any term available to signify what inflation used to signify. It is impossible to fight a policy which you cannot name. Statesmen and writers no longer have the opportunity of resorting to a terminology accepted and understood by the public when they want to question the expediency of issuing huge amounts of additional money. They must enter into a detailed analysis and description of this policy with full particulars and minute accounts whenever they want to refer to it, and they must repeat this bothersome procedure in every sentence in which they deal with the subject. As this policy has no name, it becomes self-understood and a matter of fact. It goes on luxuriantly.

The second mischief is that those engaged in futile and hopeless attempts to fight the inevitable consequences of inflation—the rise in prices—are disguising their endeavors as a fight against inflation. Edition: current; Page: [424] While merely fighting symptoms, they pretend to fight the root causes of the evil. Because they do not comprehend the causal relation between the increase in the quantity of money on the one hand and the rise in prices on the other, they practically make things worse. The best example was provided by the subsidies granted in the Second World War on the part of the governments of the United States, Canada, and Great Britain to farmers. Price ceilings reduce the supply of the commodities concerned because production involves a loss for the marginal producers. To prevent this outcome the governments granted subsidies to the farmers producing at the highest costs. These subsidies were financed out of additional increases in the quantity of money. If the consumers had had to pay higher prices for the products concerned, no further inflationary effects would have emerged. The consumers would have had to use for such surplus expenditure only money which had already been issued previously. Thus the confusion of inflation and its consequences in fact can directly bring about more inflation.

It is obvious that this new-fangled connotation of the terms inflation and deflation is utterly confusing and misleading and must be unconditionally rejected.

7: Monetary Calculation and Changes in Purchasing Power

Monetary calculation reckons with the prices of commodities and services as they were determined or would have been determined or presumably will be determined on the market. It is eager to detect price discrepancies and to draw conclusions from such a detection.

Cash-induced changes in purchasing power cannot be taken into account in such calculations. It is possible to put in the place of calculation based on a definite kind of money a a mode of calculating based on another kind of money b. Then the result of the calculation is made safe against adulteration on the part of changes effected in the purchasing power of a; but it can still be adulterated by changes effected in the purchasing power of b. There is no means of freeing any mode of economic calculation from the influence of changes in the purchasing power of the definite kind of money on which it is based.

All results of economic calculation and all conclusions derived from them are conditioned by the vicissitudes of cash-induced changes in purchasing power. In accordance with the rise or fall in purchasing power there emerge between items reflecting earlier prices and those reflecting later prices specific differences; the calculation shows profits or losses which are merely produced by cash-induced changes effected in the purchasing power of money. If we compare such profits or Edition: current; Page: [425] losses with the result of a calculation accomplished on the basis of a kind of money whose purchasing power had been subject to less vehement changes, we can call them imaginary or apparent only. But one must not forget that such statements are only possible as a result of the comparison of calculations carried out in different kinds of money. As there is no such thing as a money with stable purchasing power, such apparent profits and losses are present with every mode of economic calculation, no matter on what kind of money it may be based. It is impossible to distinguish precisely between genuine profits and losses and merely apparent profits and losses.

It is therefore possible to maintain that economic calculation is not perfect. However, nobody can suggest a method which could free economic calculation from these defects or design a monetary system which could remove this source of error entirely.

It is an undeniable fact that the free market has succeeded in developing a currency system which well served all the requirements both of indirect exchange and of economic calculation. The aims of monetary calculation are such that they cannot be frustrated by the inaccuracies which stem from slow and comparatively slight movements in purchasing power. Cash-induced changes in purchasing power of the extent to which they occurred in the last two centuries with metallic money, especially with gold money, cannot influence the result of the businessmen’s economic calculations so considerably as to render such calculations useless. Historical experience shows that one could, for all practical purposes of the conduct of business, manage very well with these methods of calculation. Theoretical consideration shows that it is impossible to design, still less to realize, a better method. In view of these facts it is vain to call monetary calculation imperfect. Man has not the power to change the categories of human action. He must adjust his conduct to them.

Businessmen never deemed it necessary to free economic calculation in terms of gold from its dependence on the fluctuations in purchasing power. The proposals to improve the currency system by adopting a tabular standard based on index numbers or by adopting various methods of commodity standards were not advanced with regard to business transactions and to monetary calculation. Their aim was to provide a less fluctuating standard for long-run loan contracts. Businessmen did not even consider it expedient to modify their accounting methods in those regards in which it would have been easy to narrow down certain errors induced by fluctuations in purchasing power. It would, for instance, have been possible to discard the practice of writing off durable equipment by means of yearly Edition: current; Page: [426] depreciation quotas, invariably fixed as a percentage of the cost of its acquisition. In its place one could resort to the device of laying aside in renewal funds as much as seems necessary to provide the full cost of the replacement at the time when it is required. But business was not eager to adopt such a procedure.

All this is valid only with regard to money which is not subject to rapid, big cash-induced changes in purchasing power. But money with which such rapid and big changes occur loses its suitability to serve as a medium of exchange altogether.

8: The Anticipation of Expected Changes in Purchasing Power

The deliberations of the individuals which determine their conduct with regard to money are based on their knowledge concerning the prices of the immediate past. If they lacked this knowledge, they would not be in a position to decide what the appropriate height of their cash holdings should be and how much they should spend for the acquisition of various goods. A medium of exchange without a past is unthinkable. Nothing can enter into the function of a medium of exchange which was not already previously an economic good and to which people assigned exchange value already before it was demanded as such a medium.

But the purchasing power handed down from the immediate past is modified by today’s demand for and supply of money. Human action is always providing for the future, be it sometimes only the future of the impending hour. He who buys, buys for future consumption and production. As far as he believes that the future will differ from the present and the past, he modifies his valuation and appraisement. This is no less true with regard to money than it is with regard to all vendible goods. In this sense we may say that today’s exchange value of money is an anticipation of tomorrow’s exchange value. The basis of all judgments concerning money is its purchasing power as it was in the immediate past. But as far as cash-induced changes in purchasing power are expected, a second factor enters the scene, the anticipation of these changes.

He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief; accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding. As long as such speculative anticipations are limited to some commodities, they do not bring about a general tendency toward changes in cash holding. But it is different if people Edition: current; Page: [427] believe that they are on the eve of big cash-induced changes in purchasing power. When they expect that the money prices of all goods will rise or fall, they expand or restrict their purchases. These attitudes strengthen and accelerate the expected tendencies considerably. This goes on until the point is reached beyond which no further changes in the purchasing power of money are expected. Only then does this inclination to buy or to sell stop and do people begin again to increase or to decrease their cash holdings.

But if once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by the progressive fall in purchasing power. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome. This phenomenon was, in the great European inflations of the ’twenties, called flight into real goods (Flucht in die Sachwerte) or crack-up boom (Katastrophenhausse). The mathematical economists are at a loss to comprehend the causal relation between the increase in the quantity of money and what they call “velocity of circulation.”

The characteristic mark of this phenomenon is that the increase in the quantity of money causes a fall in the demand for money. The tendency toward a fall in purchasing power as generated by the increased supply of money is intensified by the general propensity to restrict cash holdings which it brings about. Eventually a point is reached where the prices at which people would be prepared to part with “real” goods discount to such an extent the expected progress in the fall of purchasing power that nobody has a sufficient amount of cash at hand to pay them. The monetary system breaks down; all transactions in the money concerned cease; a panic makes its purchasing power vanish altogether. People return either to barter or to the use of another kind of money.

The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent.

This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the Edition: current; Page: [428] country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux [(French) land-warrants, issued in 1796 by the French Revolutionary Government, supposedly to serve as money] in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last.

9: The Specific Value of Money

As far as a good used as money is valued and appraised on account of the services it renders for nonmonetary purposes, no problems are raised which would require special treatment. The task of the theory of money consists merely in dealing with that component in the valuation of money which is conditioned by its function as a medium of exchange.

In the course of history various commodities have been employed as media of exchange. A long evolution eliminated the greater part of these commodities from the monetary function. Only two, the precious metals gold and silver, remained. In the second part of the nineteenth century more and more governments deliberately turned toward the demonetization of silver.

In all these cases what is employed as money is a commodity which is used also for nonmonetary purposes. Under the gold standard, gold is money and money is gold. It is immaterial whether or not the laws assign legal tender quality only to gold coins minted by the government. What counts is that these coins really contain a fixed weight Edition: current; Page: [429] of gold and that every quantity of bullion can be transformed into coins. Under the gold standard the dollar and the pound sterling were merely names for a definite weight of gold, within very narrow margins precisely determined by the laws. We may call such a sort of money commodity money.

A second sort of money is credit money. Credit money evolved out of the use of money-substitutes. It was customary to use claims, payable on demand and absolutely secure, as substitutes for the sum of money to which they gave a claim. (We shall deal with the features and problems of money-substitutes in the next sections.) The market did not stop using such claims when one day their prompt redemption was suspended and thereby doubts about their safety and the solvency of the obligee were raised. As long as these claims had been daily maturing claims against a debtor of undisputed solvency and could be collected without notice and free of expense, their exchange value was equal to their face value; it was this perfect equivalence which assigned to them the character of money-substitutes. Now, as redemption was suspended, the maturity date postponed to an undetermined day, and consequently doubts about the solvency of the debtor or at least about his willingness to pay emerged, they lost a part of the value previously ascribed to them. They were now merely claims, which did not bear interest, against a questionable debtor and falling due on an undefined day. But as they were used as media of exchange, their exchange value did not drop to the level to which it would have dropped if they were merely claims.

One can fairly assume that such credit money could remain in use as a medium of exchange even if it were to lose its character as a claim against a bank or a treasury, and thus would become fiat money. Fiat money is a money consisting of mere tokens which can neither be employed for any industrial purposes nor convey a claim against anybody.

It is not a task of catallactics but of economic history to investigate whether there appeared in the past specimens of fiat money or whether all the sorts of money which were not commodity money were credit money. The only thing that catallactics has to establish is that the possibility of the existence of fiat money must be admitted.

The important thing to be remembered is that with every sort of money, demonetization—i.e., the abandonment of its use as a medium of exchange—must result in a serious fall of its exchange value. What this practically means has become manifest when in the last ninety years the use of silver as commodity money has been progressively restricted.

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There are specimens of credit money and fiat money which are embodied in metallic coins. Such money is printed, as it were, on silver, nickel, or copper. If such a piece of fiat money is demonetized, it still retains exchange value as a piece of metal. But this is only a very small indemnification of the owner. It has no practical importance.

The keeping of cash holding requires sacrifices. To the extent that a man keeps money in his pockets or in his balance with a bank, he forsakes the instantaneous acquisition of goods he could consume or employ for production. In the market economy these sacrifices can be precisely determined by calculation. They are equal to the amount of originary interest he would have earned by investing the sum. The fact that a man takes this falling off into account is proof that he prefers the advantages of cash holding to the loss in interest yield.

It is possible to specify the advantages which people expect from keeping a definite amount of cash. But it is a delusion to assume that an analysis of these motives could provide us with a theory of the determination of purchasing power which could do without the notions of cash holding and demand for and supply of money.12 The advantages and disadvantages derived from cash holding are not objective factors which could directly influence the size of cash holdings. They are put on the scales by each individual and weighed against one another. The result is a subjective judgment of value, colored by the individual’s personality. Different people and the same people at different times value the same objective facts in a different way. Just as knowledge of a man’s wealth and his physical condition does not tell us how much he would be prepared to spend for food of a certain nutritive power, so knowledge about data concerning a man’s material situation does not enable us to make definite assertions with regard to the size of his cash holding.

10: The Import of the Money Relation

The money relation, i.e., the relation between demand for and supply of money, uniquely determines the price structure as far as the reciprocal exchange ratio between money and the vendible commodities and services is involved.

If the money relation remains unchanged, neither an inflationary (expansionist) nor a deflationary (contractionist) pressure on trade, business, production, consumption, and employment can emerge. The assertions to the contrary reflect the grievances of people reluctant to Edition: current; Page: [431] adjust their activities to the demands of their fellow men as manifested on the market. However, it is not on account of an alleged scarcity of money that prices of agricultural products are too low to secure to the submarginal farmers proceeds of the amount they would like to earn. The cause of these farmers’ distress is that other farmers are producing at lower costs.

An increase in the quantity of goods produced, other things being unchanged, must bring about an improvement in people’s conditions. Its consequence is a fall in the money prices of the goods the production of which has been increased. But such a fall in money prices does not in the least impair the benefits derived from the additional wealth produced. One may consider as unfair the increase in the share of the additional wealth which goes to the creditors, although such criticisms are questionable as far as the rise in purchasing power has been correctly anticipated and adequately taken into account by a negative price premium.13 But one must not say that a fall in prices caused by an increase in the production of the goods concerned is the proof of some disequilibrium which cannot be eliminated otherwise than by increasing the quantity of money. Of course, as a rule every increase in production of some or of all commodities requires a new allocation of factors of production to the various branches of business. If the quantity of money remains unchanged, the necessity of such a reallocation becomes visible in the price structure. Some lines of production become more profitable, while in others profits drop or losses appear. Thus the operation of the market tends to eliminate these much discussed disequilibria. It is possible by means of an increase in the quantity of money to delay or to interrupt this process of adjustment. It is impossible either to make it superfluous or less painful for those concerned.

If the government-made cash-induced changes in the purchasing power of money resulted only in shifts of wealth from some people to other people, it would not be permissible to condemn them from the point of view of catallactics’ scientific neutrality. It is obviously fraudulent to justify them under the pretext of the commonweal or public welfare. But one could still consider them as political measures suitable to promote the interests of some groups of people at the expense of others without further detriment. However, there are still other things involved.

It is not necessary to point out the consequences to which a continued deflationary policy must lead. Nobody advocates such a Edition: current; Page: [432] policy. The favor of the masses and of the writers and politicians eager for applause goes to inflation. With regard to these endeavors we must emphasize three points. First: Inflationary or expansionist policy must result in overconsumption on the one hand and in malinvestment on the other. It thus squanders capital and impairs the future state of want-satisfaction.14 Second: The inflationary process does not remove the necessity of adjusting production and reallocating resources. It merely postpones it and thereby makes it more troublesome. Third: Inflation cannot be employed as a permanent policy because it must, when continued, finally result in a breakdown of the monetary system.

A retailer or innkeeper can easily fall prey to the illusion that all that is needed to make him and his colleagues more prosperous is more spending on the part of the public. In his eyes the main thing is to impel people to spend more. But it is amazing that this belief could be presented to the world as a new social philosophy. Lord Keynes and his disciples make the lack of the propensity to consume responsible for what they deem unsatisfactory in economic conditions. What is needed, in their eyes, to make men more prosperous is not an increase in production, but an increase in spending. In order to make it possible for people to spend more, an “expansionist” policy is recommended.

This doctrine is as old as it is bad. Its analysis and refutation will be undertaken in the chapter dealing with the trade cycle.15

11: The Money-Substitutes

Claims to a definite amount of money, payable and redeemable on demand, against a debtor about whose solvency and willingness to pay there does not prevail the slightest doubt, render to the individual all the services money can render, provided that all parties with whom he could possibly transact business are perfectly familiar with these essential qualities of the claims concerned: daily maturity as well as undoubted solvency and willingness to pay on the part of the debtor. We may call such claims money-substitutes, as they can fully replace money in an individual’s or a firm’s cash holding. The technical and legal features of the money-substitutes do not concern catallactics. A money-substitute can be embodied either in a banknote or in a demand deposit with a bank subject to check (“check-book money” or deposit currency), provided the bank is prepared to Edition: current; Page: [433] exchange the note or the deposit daily free of charge against money proper. Token coins are also money-substitutes, provided the owner is in a position to exchange them at need, free of expense and without delay, against money. To achieve this it is not required that the government be bound by law to redeem them. What counts is the fact that these tokens can be really converted free of expense and without delay. If the total amount of token coins issued is kept within reasonable limits, no special provisions on the part of the government are necessary to keep their exchange value at par with their face value. The demand of the public for small change gives everybody the opportunity to exchange them easily against pieces of money. The main thing is that every owner of a money-substitute is perfectly certain that it can, at every instant and free of expense, be exchanged against money.

If the debtor—the government or a bank—keeps against the whole amount of money-substitutes a 100% reserve of money proper, we call the money-substitute a money-certificate. The individual money-certificate is—not necessarily in a legal sense, but always in the catallactic sense—a representative of a corresponding amount of money kept in the reserve. The issuing of money-certificates does not increase the quantity of things suitable to satisfy the demand for money for cash holding. Changes in the quantity of money-certificates therefore do not alter the supply of money and the money relation. They do not play any role in the determination of the purchasing power of money.

If the money reserve kept by the debtor against the money-substitutes issued is less than the total amount of such substitutes, we call that amount of substitutes which exceeds the reserve fiduciary media. As a rule it is not possible to ascertain whether a concrete specimen of money-substitutes is a money-certificate or a fiduciary medium. A part of the total amount of money-substitutes issued is usually covered by a money reserve held. Thus a part of the total amount of money-substitutes issued is money-certificates, the rest fiduciary media. But this fact can only be recognized by those familiar with the bank’s balance sheets. The individual banknote, deposit, or token coin does not indicate its catallactic character.

The issue of money-certificates does not increase the funds which the bank can employ in the conduct of its lending business. A bank which does not issue fiduciary media can only grant commodity credit, i.e., it can only lend its own funds and the amount of money which its customers have entrusted to it. The issue of fiduciary media enlarges the bank’s funds available for lending beyond these limits. Edition: current; Page: [434] It can now not only grant commodity credit, but also circulation credit, i.e., credit granted out of the issue of fiduciary media.

While the quantity of money-certificates is indifferent, the quantity of fiduciary media is not. The fiduciary media affect the market phenomena in the same way as money does. Changes in their quantity influence the determination of money’s purchasing power and of prices and—temporarily—also of the rate of interest.

Earlier economists applied a different terminology. Many were prepared to call the money-substitutes simply money, as they are fit to render the services money renders. However, this terminology is not expedient. The first purpose of a scientific terminology is to facilitate the analysis of the problems involved. The task of the catallactic theory of money—as differentiated from the legal theory and from the technical disciplines of bank management and accountancy—is the study of the problems of the determination of prices and interest rates. This task requires a sharp distinction between money-certificates and fiduciary media.

The term credit expansion has often been misinterpreted. It is important to realize that commodity credit cannot be expanded. The only vehicle of credit expansion is circulation credit. But the granting of circulation credit does not always mean credit expansion. If the amount of fiduciary media previously issued has consummated all its effects upon the market, if prices, wage rates, and interest rates have been adjusted to the total supply of money proper plus fiduciary media (supply of money in the broader sense), granting of circulation credit without a further increase in the quantity of fiduciary media is no longer credit expansion. Credit expansion is present only if credit is granted by the issue of an additional amount of fiduciary media, not if banks lend anew fiduciary media paid back to them by the old debtors.

12: The Limitation on the Issuance of Fiduciary Media

People deal with money-substitutes as if they were money because they are fully confident that it will be possible to exchange them at any time without delay and without cost against money. We may call those who share in this confidence and are therefore ready to deal with money-substitutes as if they were money, the clients of the issuing banker, bank, or authority. It does not matter whether or not this issuing establishment is operated according to the patterns of conduct customary in the banking business. Token coins issued by a country’s treasury are money-substitutes too, although the treasury as a rule does not enter the amount issued into its accounts as a Edition: current; Page: [435] liability and does not consider this amount a part of the national debt. It is no less immaterial whether or not the owner of a money-substitute has an actionable claim to redemption. What counts is whether the money-substitute can really be exchanged against money without delay and cost.16

Issuing money-certificates is an expensive venture. The banknotes must be printed, the token coins minted; a complicated accounting system for the deposits must be organized; the reserves must be kept in safety; then there is the risk of being cheated by counterfeit banknotes and checks. Against all these expenses stands only the slight chance that some of the banknotes issued may be destroyed and the still slighter chance that some depositors may forget their deposits. Issuing money-certificates is a ruinous business if not connected with issuing fiduciary media. In the early history of banking there were banks whose only operation consisted in issuing money-certificates. But these banks were indemnified by their clients for the costs incurred. At any rate, catallactics is not interested in the purely technical problems of banks not issuing fiduciary media. The only interest that catallactics takes in money-certificates is the connection between issuing them and the issuing of fiduciary media.

While the quantity of money-certificates is catallactically unimportant, an increase or decrease in the quantity of fiduciary media affects the determination of money’s purchasing power in the same way as do changes in the quantity of money. Hence the question of whether there are or are not limits to the increase in the quantity of fiduciary media has fundamental importance.

If the clientele of the bank includes all members of the market economy, the limit to the issue of fiduciary media is the same as that drawn to the increase in the quantity of money. A bank which is, in an isolated country or in the whole world, the only institution issuing fiduciary media and the clientele of which comprises all individuals and firms, is bound to comply in its conduct of affairs with two rules:

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First: It must avoid any action which could make the clients—i.e., the public—suspicious. As soon as the clients begin to lose confidence, they will ask for the redemption of the banknotes and withdraw their deposits. How far the bank can go on increasing its issues of fiduciary media without arousing distrust, depends on psychological factors.

Second: It must not increase the amount of fiduciary media at such a rate and with such speed that the clients get the conviction that the rise in prices will continue endlessly at an accelerated pace. For if the public believes that this is the case, they will reduce their cash holdings, flee into “real” values, and bring about the crack-up boom. It is impossible to imagine the approach of this catastrophe without assuming that its first manifestation consists in the evanescence of confidence. The public will certainly prefer exchanging the fiduciary media against money to fleeing into real values, i.e., to the indiscriminate buying of various commodities. Then the bank must go bankrupt. If the government interferes by freeing the bank from the obligation of redeeming its banknotes and of paying back the deposits in compliance with the terms of the contract, the fiduciary media become either credit money or fiat money. The suspension of specie [metallic money, usually gold or silver] payments entirely changes the state of affairs. There is no longer any question of fiduciary media, of money-certificates, and of money-substitutes. The government enters the scene with its government-made legal tender laws. The bank loses its independent existence; it becomes a tool of government policies, a subordinate office of the treasury.

The catallactically most important problems of the issuance of fiduciary media on the part of a single bank, or of banks acting in concert, the clientele of which comprehends all individuals, are not those of the limitations drawn to the amount of their issuance. We will deal with them in Chapter 20, devoted to the relations between the quantity of money and the rate of interest.

At this point of our investigations we have to scrutinize the problem of the coexistence of a multiplicity of independent banks. Independence means that every bank in issuing fiduciary media follows its own course and does not act in concert with other banks. Coexistence means that every bank has a clientele which does not include all members of the market system. For the sake of simplicity we will assume that no individual or firm is a client of more than one bank. It would not affect the result of our demonstration if we were to assume that there are also people who are clients of more than one bank and people who are not clients of any bank.

The question to be raised is not whether or not there are limits Edition: current; Page: [437] to the issuance of fiduciary media on the part of such independently coexisting banks. As there are even limits to the issuance of fiduciary media on the part of a unique bank the clientele of which comprises all people, it is obvious that there are such limits for a multiplicity of independently coexisting banks too. What we want to show is that for such a multiplicity of independently coexisting banks the limits are narrower than those drawn for a single bank with an unlimited clientele.

We assume that within a market system several independent banks have been established in the past. While previously only money was in use, these banks have introduced the use of money-substitutes a part of which are fiduciary media. Each bank has a clientele and has issued a certain quantity of fiduciary media which are kept as money-substitutes in the cash holdings of various clients. The total quantity of the fiduciary media as issued by the banks and absorbed by the cash holdings of their clients has altered the structure of prices and the monetary unit’s purchasing power. But these effects have already been consummated and at present the market is no longer stirred by any movements generated from this past credit expansion.

But now, we assume further, one bank alone embarks upon an additional issue of fiduciary media while the other banks do not follow suit. The clients of the expanding bank—whether its old clients or new ones acquired on account of the expansion—receive additional credits, they expand their business activities, they appear on the market with an additional demand for goods and services, they bid up prices. Those people who are not clients of the expanding bank are not in a position to afford these higher prices; they are forced to restrict their purchases. Thus there prevails on the market a shifting of goods from the nonclients to the clients of the expanding bank. The clients buy more from the nonclients than they sell to them; they have more to pay to the nonclients than they receive from them. But money-substitutes issued by the expanding bank are not suitable for payments to nonclients, as these people do not assign to them the character of money-substitutes. In order to settle the payments due to nonclients, the clients must first exchange the money-substitutes issued by their own—viz., the expanding bank—against money. The expanding bank must redeem its banknotes and pay out its deposits. Its reserve—we suppose that only a part of the money-substitutes it had issued had the character of fiduciary media—dwindles. The instant approaches in which the bank will—after the exhaustion of its money reserve—no longer be in a position to redeem the money-substitutes still current. In order to avoid insolvency it must as soon Edition: current; Page: [438] as possible return to a policy of strengthening its money reserve. It must abandon its expansionist methods.

This reaction of the market to a credit expansion on the part of a bank with a limited clientele has been brilliantly described by the Currency School. The special case dealt with by the Currency School referred to the coincidence of credit expansion on the part of one country’s privileged central bank or of all banks of one country and of a nonexpansionist policy on the part of the banks of other countries. Our demonstration covers the more general case of the coexistence of a multiplicity of banks with different clientele as well as the most general case of the existence of one bank with a limited clientele in a system in which the rest of the people do not patronize any bank and do not consider any claims as money-substitutes. It does not matter, of course, whether one assumes that the clients of a bank live neatly separated from those of the other banks in a definite district or country or whether they live side by side with those of the other banks. These are merely differences in the data not affecting the catallactic problems involved.

A bank can never issue more money-substitutes than its clients can keep in their cash holdings. The individual client can never keep a larger portion of his total cash holding in money-substitutes than that corresponding to the proportion which his turnover with other clients of his bank bears to his total turnover. For considerations of convenience he will, as a rule, remain far below this maximum proportion. Thus a limit is drawn to the issue of fiduciary media. We may admit that everybody is ready to accept in his current transactions indiscriminately banknotes issued by any bank and checks drawn upon any bank. But he deposits without delay with his own bank not only the checks but also the banknotes of banks of which he is not himself a client. In the further course his bank settles its accounts with the bank engaged. Thus the process described above comes into motion.

A lot of nonsense has been written about a perverse predilection of the public for banknotes issued by dubious banks. The truth is that, except for small groups of businessmen who were able to distinguish between good and bad banks, banknotes were always looked upon with distrust. It was the special charters which the governments granted to privileged banks that slowly made these suspicions disappear. The often advanced argument that small banknotes come into the hands of poor and ignorant people who cannot distinguish between good and bad notes cannot be taken seriously. The poorer the recipient of a banknote is and the less familiar he is with bank affairs, the more quickly will he spend the note and the more quickly Edition: current; Page: [439] will it return, by way of retail and wholesale trade, to the issuing bank or to people conversant with banking conditions.

It is very easy for a bank to increase the number of people who are ready to accept loans granted by credit expansion and paid out in an amount of money-substitutes. But it is very difficult for any bank to enlarge its clientele, that is, the number of people who are ready to consider these claims as money-substitutes and to keep them as such in their cash holdings. To enlarge this clientele is a troublesome and slow process, as is the acquisition of any kind of good will. On the other hand, a bank can lose its clientele very quickly. If it wants to preserve it, it must never permit any doubt about its ability and readiness to discharge all its liabilities in due compliance with the terms of the contract. A reserve must be kept large enough to redeem all banknotes which a holder may submit for redemption. Therefore no bank can content itself with issuing fiduciary media only; it must keep a reserve against the total amount of money-substitutes issued and thus combine issuing fiduciary media and money-certificates.

It was a serious blunder to believe that the reserve’s task is to provide the means for the redemption of those banknotes the holders of which have lost confidence in the bank. The confidence which a bank and the money-substitutes it has issued enjoy is indivisible. It is either present with all its clients or it vanishes entirely. If some of the clients lose confidence, the rest of them lose it too. No bank issuing fiduciary media and granting circulation credit can fulfill the obligations which it has taken over in issuing money-substitutes if all clients are losing confidence and want to have their banknotes redeemed and their deposits paid back. This is an essential feature or weakness of the business of issuing fiduciary media and granting circulation credit. No system of reserve policy and no reserve requirements as enforced by the laws can remedy it. All that a reserve can do is to make it possible for the bank to withdraw from the market an excessive amount of fiduciary media issued. If the bank has issued more banknotes than its clients can use in doing business with other clients, it must redeem such an excess.

The laws which compelled the banks to keep a reserve in a definite ratio of the total amount of deposits and of banknotes issued were effective in so far as they restricted the increase in the amount of fiduciary media and of circulation credit. They were futile as far as they aimed at safeguarding, in the event of a loss of confidence, the prompt redemption of the banknotes and the prompt payment on deposits.

The Banking School failed entirely in dealing with these problems. Edition: current; Page: [440] It was confused by a spurious idea according to which the requirements of business rigidly limit the maximum amount of convertible banknotes that a bank can issue. They did not see that the demand of the public for credit is a magnitude dependent on the banks’ readiness to lend, and that banks which do not bother about their own solvency are in a position to expand circulation credit by lowering the rate of interest below the market rate. It is not true that the maximum amount which a bank can lend if it limits its lending to discounting short-term bills of exchange resulting from the sale and purchase of raw materials and half-manufactured goods is a quantity uniquely determined by the state of business and independent of the bank’s policies. This quantity expands or shrinks with the lowering or raising of the rate of discount. Lowering the rate of interest is tantamount to increasing the quantity of what is mistakenly considered as the fair and normal requirements of business.

The Currency School gave a quite correct explanation of the recurring crises as they upset English business conditions in the ’thirties and ’forties of the nineteenth century. There was credit expansion on the part of the Bank of England and the other British banks and bankers, while there was no credit expansion, or at least not to the same degree, in the countries with which Great Britain traded. The external drain occurred as the necessary consequence of this state of affairs. Everything that the Banking School advanced in order to refute this theory was vain. Unfortunately, the Currency School erred in two respects. It never realized that the remedy it suggested, namely strict legal limitation of the amount of banknotes issued beyond the specie reserve, was not the only one. It never gave a thought to the idea of free banking. The second fault of the Currency School was that it failed to recognize that deposits subject to check are money-substitutes and, as far as their amount exceeds the reserve kept, fiduciary media, and consequently no less a vehicle of credit expansion than are banknotes. It was the only merit of the Banking School that it recognized that what is called deposit currency is a money-substitute no less than banknotes. But except for this point, all the doctrines of the Banking School were spurious. It was guided by contradictory ideas concerning money’s neutrality; it tried to refute the quantity theory of money by referring to a deus ex machina, the much talked about hoards, and it misconstrued entirely the problems of the rate of interest.

It must be emphasized that the problem of legal restrictions upon the issuance of fiduciary media could emerge only because governments Edition: current; Page: [441] had granted special privileges to one or several banks and had thus prevented the free evolution of banking. If the governments had never interfered for the benefit of special banks, if they had never released some banks from the obligation, incumbent upon all individuals and firms in the market economy, to settle their liabilities in full compliance with the terms of the contract, no bank problem would have come into being. The limits which are drawn to credit expansion would have worked effectively. Considerations of its own solvency would have forced every bank to cautious restraint in issuing fiduciary media. Those banks which would not have observed these indispensable rules would have gone bankrupt, and the public, warned through damage, would have become doubly suspicious and reserved.

The attitudes of the European governments with regard to banking were from the beginning insincere and mendacious. The pretended solicitude for the nation’s welfare, for the public in general, and for the poor ignorant masses in particular was a mere blind. The governments wanted inflation and credit expansion, they wanted booms and easy money. Those Americans who twice succeeded in doing away with a central bank were aware of the dangers of such institutions; it was only too bad that they failed to see that the evils they fought were present in every kind of government interference with banking. Today even the most bigoted étatists cannot deny that all the alleged evils of free banking count little when compared with the disastrous effects of the tremendous inflations which the privileged and government-controlled banks have brought about.

It is a fable that governments interfered with banking in order to restrict the issue of fiduciary media and to prevent credit expansion. The idea that guided governments was, on the contrary, the lust for inflation and credit expansion. They privileged banks because they wanted to widen the limits that the unhampered market draws to credit expansion or because they were eager to open to the treasury a source of revenue. For the most part both of these considerations motivated the authorities. They were convinced that the fiduciary media are an efficient means of lowering the rate of interest, and asked the banks to expand credit for the benefit of both business and the treasury. Only when the undesired effects of credit expansion became visible, were laws enacted to restrict the issue of banknotes—and sometimes also of deposits—not covered by specie. The establishment of free banking was never seriously considered precisely because it would have been too efficient in restricting credit expansion. For rulers, writers, and the public were unanimous in the belief that business Edition: current; Page: [442] has a fair claim to a “normal” and “necessary” amount of circulation credit and that this amount could not be attained under free banking.17

Many governments never looked upon the issuance of fiduciary media from a point of view other than that of fiscal concerns. In their eyes the foremost task of the banks was to lend money to the treasury. The money-substitutes were favorably considered as pacemakers for government-issued paper money. The convertible banknote was merely a first step on the way to the nonredeemable banknote. With the progress of statolatry and the policy of interventionism these ideas have become general and are no longer questioned by anybody. No government is willing today to give any thought to the program of free banking because no government wants to renounce what it considers a handy source of revenue. What is called today financial war preparedness is merely the ability to procure by means of privileged and government-controlled banks all the money a warring nation may need. Radical inflationism, although not admitted explicitly, is an essential feature of the economic ideology of our age.

But even at the time liberalism enjoyed its highest prestige and governments were more eager to preserve peace and well-being than to foment war, death, destruction, and misery, people were biased in dealing with the problems of banking. Outside of the Anglo-Saxon countries public opinion was convinced that it is one of the main tasks of good government to lower the rate of interest and that credit expansion is the appropriate means for the attainment of this end.

Great Britain was free from these errors when in 1844 it reformed its bank laws. But the two shortcomings of the Currency School vitiated this famous act. On one hand, the system of government interference with banking was preserved. On the other hand, limits were placed only on the issuance of banknotes not covered by specie. The fiduciary media were suppressed only in the shape of banknotes. They could thrive as deposit currency.

In carrying the idea implied in the Currency Theory to its full logical conclusion, one could suggest that all banks be forced by law to keep against the total amount of money-substitutes (banknotes plus demand deposits) a 100 per cent money reserve. This is the core of Professor Irving Fisher’s 100 per cent plan. But Professor Fisher combined his plan with his proposals concerning the adoption of an Edition: current; Page: [443] index-number standard. It has been pointed out already why such a scheme is illusory and tantamount to open approval of the government’s power to manipulate purchasing power according to the appetites of powerful pressure groups. But even if the 100 per cent reserve plan were to be adopted on the basis of the unadulterated gold standard, it would not entirely remove the drawbacks inherent in every kind of government interference with banking. What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract. If banks are preserved as privileged establishments subject to special legislative provisions, the tool remains that governments can use for fiscal purposes. Then every restriction imposed upon the issuance of fiduciary media depends upon the government’s and the parliament’s good intentions. They may limit the issuance for periods which are called normal. The restriction will be withdrawn whenever a government deems that an emergency justifies resorting to extraordinary measures. If an administration and the party backing it want to increase expenditure without jeopardizing their popularity through the imposition of higher taxes, they will always be ready to call their impasse an emergency. Recourse to the printing press and to the obsequiousness of bank managers willing to oblige the authorities regulating their conduct of affairs is the foremost means of governments eager to spend money for purposes for which the taxpayers are not ready to pay higher taxes.

Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular—one is tempted to say normal—feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.

Looking backward upon the history of the last two centuries, one cannot help realizing that the blunders committed by liberalism in handling the problems of banking were a deadly blow to the market economy. There was no reason whatever to abandon the principle of free enterprise in the field of banking. The majority of liberal politicians simply surrendered to the popular hostility against money-lending Edition: current; Page: [444] and interest taking. They failed to realize that the rate of interest is a market phenomenon which cannot be manipulated ad libitum by the authorities or by any other agency. They adopted the superstition that lowering the rate of interest is beneficial and that credit expansion is the right means of attaining such cheap money. Nothing harmed the cause of liberalism more than the almost regular return of feverish booms and of the dramatic breakdown of bull markets followed by lingering slumps. Public opinion has become convinced that such happenings are inevitable in the unhampered market economy. People did not conceive that what they lamented was the necessary outcome of policies directed toward a lowering of the rate of interest by means of credit expansion. They stubbornly kept to these policies and tried in vain to fight their undesired consequences by more and more government interference.

Observations on the Discussions Concerning Free Banking

The Banking School taught that an overissuance of banknotes is impossible if the bank limits its business to the granting of short-term loans.18 When the loan is paid back at maturity, the banknotes return to the bank and thus disappear from the market. However, this happens only if the bank restricts the amount of credits granted. (But even then it would not undo the effects of its previous credit expansion. It would merely add to it the effects of a later credit contraction.) The regular course of affairs is that the bank replaces the bills expired and paid back by discounting new bills of exchange. Then to the amount of banknotes withdrawn from the market by the repayment of the earlier loan there corresponds an amount of newly issued banknotes.

The concatenation which sets a limit to credit expansion under a system of free banking works in a different way. It has no reference whatever to the process which this so-called Principle of Fullarton has in mind. It is brought about by the fact that credit expansion in itself does not expand a bank’s clientele, viz., the number of people who assign to the demand-claims against this bank the character of money-substitutes. Since the overissuance of fiduciary media on the part of one bank, as has been shown above, increases the amount to be paid by the expanding bank’s clients to other people, it increases concomitantly the demand for the redemption of its money-substitutes. It thus forces the expanding bank back to a restraint.

This fact was never questioned with regard to demand deposits subject to check. It is obvious that an expanding bank would very soon find itself in a difficult position in clearing with the other banks. Edition: current; Page: [445] However, people sometimes maintained that things are different as far as banknotes are concerned.

In dealing with the problems of money-substitutes, catallactics maintains that the claims in question are dealt with by a number of people like money, that they are, like money, given away and received in transactions and kept in cash holdings. Everything that catallactics asserts with regard to money-substitutes presupposes this state of affairs. But it would be preposterous to believe that every banknote issued by any bank really becomes a money-substitute. What makes a banknote a money-substitute is the special kind of good will of the issuing bank. The slightest doubt concerning the bank’s ability or willingness to redeem every banknote without any delay at any time and with no expense to the bearer impairs this special good will and deprives the banknotes of their character as a money-substitute. We may assume that everybody not only is prepared to get such questionable banknotes as a loan but also prefers to receive them as payment instead of waiting longer. But if any doubts exist concerning their prime character, people will hurry to get rid of them as soon as possible. They will keep in their cash holdings money and such money-substitutes as they consider perfectly safe and will dispose of the suspect banknotes. These banknotes will be traded at a discount, and this fact will carry them back to the issuing bank which alone is bound to redeem them at their full face value.

The issue can still better be clarified by reviewing banking conditions in continental Europe. Here the commercial banks were free from any limitation concerning the amount of deposits subject to check. They would have been in a position to grant circulation credit and thus expand credit by adopting the methods applied by the banks of the Anglo-Saxon countries. However, the public was not ready to treat such bank deposits as money-substitutes. As a rule a man who received a check cashed it immediately and thereby withdrew the amount from the bank. It was impossible for a commercial bank to lend, except for negligible sums, by crediting the debtor’s account. As soon as the debtor wrote out a check, a withdrawal of the amount concerned from the bank resulted. Only big business treated deposits as money-substitutes. Although the Central Banks in most of these countries were not submitted to any legal restrictions with regard to their deposit business, they were prevented from using it as a vehicle of large-scale credit expansion because the clientele for deposit currency was too small. Banknotes were practically the sole instrument of circulation credit and credit expansion.

In the ’eighties of the nineteenth century the Austrian government embarked upon a project of popularizing checkbook money by establishing a checking account department with the Post Office Savings Service. It succeeded to some degree. Balances with this department of Edition: current; Page: [446] the Post Office were treated as money-substitutes by a clientele which was broader than that of the checking account department of the country’s Central Bank of Issue. The system was later preserved by the new states which in 1918 succeeded the Habsburg Empire. It has also been adopted by many other European nations, for instance Germany. It is important to realize that this kind of deposit currency was a purely governmental venture and that the circulation credit that the system granted was exclusively lent to the governments. It is characteristic that the name of the Austrian Post Office Savings Institution, and likewise of most of its foreign replicas, was not Savings Bank, but Savings Office (Amt). Apart from these demand deposits with the government post system in most of the non-Anglo-Saxon countries, banknotes—and, to a small extent, also deposits with the government-controlled Central Bank of Issue—are the main vehicles of circulation credit. In speaking of credit expansion with regard to these countries, one refers almost entirely to banknotes.

In the United States many employers pay salaries and even wages by writing out checks. As far as the payees immediately cash the checks received and withdraw the whole amount from the bank, the method means merely that the onerous burden of manipulating coins and banknotes is shifted from the employer’s cashier to the bank’s cashier. It has no catallactic implications. If all citizens were to deal in this way with checks received, the deposits would not be money-substitutes and could not be used as instruments of circulation credit. It is solely the fact that a considerable part of the public looks upon deposits as money-substitutes that makes them what is popularly called checkbook money or deposit currency.

It is a mistake to associate with the notion of free banking the image of a state of affairs under which everybody is free to issue banknotes and to cheat the public ad libitum. People often refer to the dictum of an anonymous American quoted by Tooke: “Free trade in banking is free trade in swindling.” However, freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865: “I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.”19

People may uphold the opinion that banknotes are more handy than coins and that considerations of convenience recommend their use. As far as this is the case, the public would be prepared to pay a premium for the avoidance of the inconveniences involved in carrying a heavy weight of coins in their pockets. Thus in earlier days banknotes issued Edition: current; Page: [447] by banks of unquestionable solvency stood at a slight premium as against metallic currency. Thus travelers’ checks are rather popular although the bank issuing them charges a commission for their issuance. But all this has no reference whatever to the problem in question. It does not provide a justification for the policies urging the public to resort to the use of banknotes. Governments did not foster the use of banknotes in order to avoid inconvenience to ladies shopping. Their idea was to lower the rate of interest and to open a source of cheap credit to their treasuries. In their eyes the increase in the quantity of fiduciary media was a means of promoting welfare.

Banknotes are not indispensable. All the economic achievements of capitalism would have been accomplished if they had never existed. Besides, deposit currency can do all the things banknotes do. And government interference with the deposits of commercial banks cannot be justified by the hypocritical pretext that poor ignorant wage earners and farmers must be protected against wicked bankers.

But, some people may ask, what about a cartel of the commercial banks? Could not the banks collude for the sake of a boundless expansion of their issuance of fiduciary media? The objection is preposterous. As long as the public is not, by government interference, deprived of the right of withdrawing its deposits, no bank can risk its own good- will by collusion with banks whose good will is not so high as its own. One must not forget that every bank issuing fiduciary media is in a rather precarious position. Its most valuable asset is its reputation. It must go bankrupt as soon as doubts arise concerning its perfect trustworthiness and solvency. It would be suicidal for a bank of good standing to link its name with that of other banks with a poorer goodwill. Under free banking a cartel of the banks would destroy the country’s whole banking system. It would not serve the interests of any bank.

For the most part the banks of good repute are blamed for their conservatism and their reluctance to expand credit. In the eyes of people not deserving of credit such restraint appears as a vice. But it is the first and supreme rule for the conduct of banking operations under free banking.

It is extremely difficult for our contemporaries to conceive of the conditions of free banking because they take government interference with banking for granted and as necessary. However, one must remember that this government interference was based on the erroneous assumption that credit expansion is a proper means of lowering the rate of interest permanently and without harm to anybody but the callous capitalists. The governments interfered precisely because they knew that free banking keeps credit expansion within narrow limits.

Economists may be right in asserting that the present state of banking makes government interference with banking problems advisable. Edition: current; Page: [448] But this present state of banking is not the outcome of the operation of the unhampered market economy. It is a product of the various governments’ attempts to bring about the conditions required for large-scale credit expansion. If the governments had never interfered, the use of banknotes and of deposit currency would be limited to those strata of the population who know very well how to distinguish between solvent and insolvent banks. No large-scale credit expansion would have been possible. The governments alone are responsible for the spread of the superstitious awe with which the common man looks upon every bit of paper upon which the treasury or agencies which it controls have printed the magical words legal tender.

Government interference with the present state of banking affairs could be justified if its aim were to liquidate the unsatisfactory conditions by preventing or at least seriously restricting any further credit expansion. In fact, the chief objective of present-day government interference is to intensify further credit expansion. This policy is doomed to failure. Sooner or later it must result in a catastrophe.

13: The Size and Composition of Cash Holdings

The total amount of money and money-substitutes is kept by individuals and firms in their cash holdings. The share of each is determined by marginal utility. Each is eager to keep a certain portion of his total wealth in cash. He gets rid of an excess of cash by increased purchases and remedies a deficiency of cash by increased sales. The popular terminology confusing the demand for money for cash holding and the demand for wealth and vendible goods must not delude an economist.

What is valid with regard to individuals and firms is no less true with regard to every sum of the cash holdings of a number of individuals and firms. The point of view from which we treat a number of such individuals and firms as a totality and sum up their cash holdings is immaterial. The cash holdings of a city, a province, or a country is the sum of the cash holdings of all its residents.

Let us assume that the market economy uses only one kind of money and that money-substitutes are either unknown or used in the whole area by everybody without any difference. There are, for example, gold money and redeemable banknotes, issued by a world bank and treated by everybody as money-substitutes. On these assumptions measures hindering the exchange of commodities and services do not affect the state of monetary affairs and the size of cash holdings. Tariffs, embargoes, and migration barriers affect the tendencies toward an equalization of prices, wages, and interest rates. They do not react directly upon cash holdings.

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If a government aims at increasing the amount of cash kept by its subjects, it must order them to deposit a certain amount with an office and to leave it there untouched. The necessity of procuring this amount would force everybody to sell more and to buy less; domestic prices would drop; exports would be increased and imports reduced; a quantity of cash would be imported. But if the government were simply to obstruct the importation of goods and the exportation of money, it would fail to attain its goal. If imports drop, other things being equal, exports drop concomitantly.

The role money plays in international trade is not different from that which it plays in domestic trade. Money is no less a medium of exchange in foreign trade than it is in domestic trade. Both in domestic trade and in international trade purchases and sales result in a more than passing change in the cash holdings of individuals and firms only if people are purposely intent upon increasing or restricting the size of their cash holdings. A surplus of money flows into a country only when its residents are more eager to increase their cash holdings than are the foreigners. An outflow of money occurs only if the residents are more eager to reduce their cash holdings than are the foreigners. A transfer of money from one country into another country which is not compensated by a transfer in the opposite direction is never the unintended result of international trade transactions. It is always the outcome of intended changes in the cash holdings of the residents. Just as wheat is exported only if a country’s residents want to export a surplus of wheat, so money is exported only if the residents want to export a sum of money which they consider as a surplus.

If a country turns to the employment of money-substitutes which are not employed abroad, such a surplus emerges. The appearance of these money-substitutes is tantamount to an increase in the country’s supply of money in the broader sense, i.e., supply of money plus fiduciary media; it brings about a surplus in the supply of money in the broader sense. The residents are eager to get rid of their share in the surplus by increasing their purchases either of domestic or of foreign goods. In the first case exports drop and in the second case imports increase. In both cases the surplus of money goes abroad. As, according to our assumption, money-substitutes cannot be exported, only money proper flows out. The result is that within the domestic supply of money in the broader sense (money 1 fiduciary media) the portion of money drops and the portion of fiduciary media increases. The domestic stock of money in the narrower sense is now smaller than it was previously.

Now, we assume further, the domestic money-substitutes cease Edition: current; Page: [450] to be money-substitutes. The bank which issued them no longer redeems them in money. These former money-substitutes are now claims against a bank which does not fulfill its obligations, a bank whose ability and willingness to pay its debts is questionable. Nobody knows whether and when they will ever be redeemed. But it may be that these claims are used by the public as credit money. As money-substitutes they had been considered as equivalents of the sum of money to which they gave a claim payable at any moment. As credit money they are now traded at a discount.

At this point the government may interfere. It decrees that these pieces of credit money are legal tender at their face value.20 Every creditor is bound to accept them in payment at their face value. No trader is free to discriminate against them. The decree tries to force the public to treat things of different exchange value as if they had the same exchange value. It interferes with the structure of prices as determined by the market. It fixes minimum prices for the credit money and maximum prices for the commodity money (gold) and foreign exchange. The result is not what the government aimed at. The difference in exchange value between credit money and gold does not disappear. As it is forbidden to employ the coins according to their market price, people no longer employ them in buying and selling and in paying debts. They keep them or they export them. The commodity money disappears from the domestic market. Bad money, says Gresham’s Law, drives good money out of the country. It would be more correct to say that the money which the government’s decree has undervalued disappears from the market and the money which the decree has over-valued remains.

The outflow of commodity money is thus not the effect of an unfavorable balance of payments, but the effect of a government interference with the price structure.

14: Balances of Payments

The confrontation of the money equivalent of all incomings and outgoings of an individual or a group of individuals during any particular period of time is called the balance of payments. The credit side and the debit side are always equal. The balance is always in balance.

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If we want to know an individual’s position in the frame of the market economy, we must look at his balance of payments. It tells us everything about the role he plays in the system of the social division of labor. It shows what he gives to his fellow men and what he receives or takes from them. It shows whether he is a self-supporting decent citizen or a thief or an almsman. It shows whether he consumes all his proceeds or whether he saves a part of them. There are many human things which are not reflected in the sheets of the ledger; there are virtues and achievements, vices and crimes that do not leave any traces in the accounts. But as far as a man is integrated into social life and activities, as far as he contributes to the joint effort of society and his contributions are appreciated by his fellow men, and as far as he consumes what is or could be sold and bought on the market, the information conveyed is complete.

If we combine the balances of payments of a definite number of individuals and leave out of account the items referring to transactions between the members of this group, we draw up the group’s balance of payment. This balance tells us how the members of the group, considered as an integrated complex of people, are connected with the rest of the market society. Thus we can draw up the balance of payments of the members of the New York Bar, of the Belgian farmers, of the residents of Paris, or of those of the Swiss Canton of Bern. Statisticians are mostly interested in establishing the balance of payments of the residents of the various countries which are organized as independent nations.

While an individual’s balance of payments conveys exhaustive information about his social position, a group’s balance discloses much less. It says nothing about the mutual relations between the members of the group. The greater the group is and the less homogeneous its members are, the more defective is the information vouchsafed by the balance of payments. The balance of payments of Denmark tells more about the conditions of the Danes than the United States balance of payments about the conditions of the Americans. If one wants to describe a country’s social and economic condition, one does not need to deal with every single inhabitant’s personal balance of payments. But one must not form other groups than such as are composed of members who are by and large homogeneous in their social standing and their economic activities.

Reading balances of payments is thus very instructive. However, to guard against popular fallacies, one must know how to interpret them.

It is customary to list separately the monetary and the nonmonetary items of a country’s balance of payments. One calls the balance Edition: current; Page: [452] favorable if there is a surplus of the imports of money and bullion over the exports of money and bullion. One calls the balance unfavorable if the exports of money and bullion exceed the imports. This terminology stems from inveterate Mercantilist errors unfortunately still surviving in spite of the devastating criticism of the economists. The imports and exports of money and bullion are viewed as the unintentional outcome of the configuration of the nonmonetary items of the balance of payments. This opinion is utterly fallacious. An excess in the exports of money and bullion is not the product of an unhappy concatenation of circumstances that befalls a nation like an act of God. It is the result of the fact that the residents of the country concerned are intent upon reducing the amount of money held and upon buying goods instead. This is why the balance of payments of the gold-producing countries is as a rule “unfavorable”; this is why the balance of payments of a country substituting fiduciary media for a part of its money stock is “unfavorable” as long as this process goes on.

No provident action on the part of a paternal authority is required lest a country lose its whole money stock by an unfavorable balance of payments. Things are in this regard not different between the personal balances of payments of individuals and those of groups. Neither are they different between the balances of payments of a city or a district and those of a sovereign nation. No government interference is needed to prevent the residents of New York from spending all their money in dealings with the other forty-nine states of the Union. As long as any American attaches any weight to the keeping of cash, he will spontaneously take charge of the matter. Thus he will contribute his share to the maintenance of an adequate supply of money in his country. But if no American were interested in keeping any cash holding, no government measure concerning foreign trade and the settlement of international payments could prevent an outflow of America’s total monetary stock. A rigidly enforced embargo upon the exportation of money and bullion would be required.

15: Interlocal Exchange Rates

Let us first assume that there is only one kind of money. Then with regard to money’s purchasing power at various places the same is valid as with regard to commodity prices. The final price of cotton in Liverpool cannot exceed the final price in Houston, Texas, by more than the cost of transportation. As soon as the price in Liverpool rises to a higher point, merchants will ship cotton to Liverpool Edition: current; Page: [453] and thus will bring about a tendency toward a return to the final price. In the absence of institutional obstacles, the price of an order for the payment of a definite amount of guilders in Amsterdam cannot rise in New York above the amount determined by the costs involved by reminting the coins, shipment, insurance, and the interest during the period required for all these manipulations. As soon as the difference rises above this point—the gold export point—it becomes profitable to ship gold from New York to Amsterdam. Such shipments force the guilder exchange rate in New York down below the gold export point. A difference between the configuration of interlocal exchange rates for commodities and those for money is brought about by the fact that as a rule commodities move only in one direction, namely, from the places of surplus production to those of surplus consumption. Cotton is shipped from Houston to Liverpool and not from Liverpool to Houston. Its price is lower in Houston than in Liverpool by the amount of shipping costs. But money is shipped now this way, now that.

The error of those who try to interpret the fluctuations of the interlocal exchange rates and the interlocal shipments of money as determined by the configuration of the nonmonetary items of the balance of payments is that they assign to money an exceptional position. They do not see that with regard to interlocal exchange rates there is no difference between money and commodities. If cotton trade between Houston and Liverpool is possible at all, the cotton prices at these two places cannot differ by more than the total amount of costs required for shipment. In the same way in which there is a flow of cotton from the southern parts of the United States to Europe, gold flows from the gold-producing countries like South Africa to Europe.

Let us disregard triangular trade and the case of the gold-producing countries and let us assume that the individuals and firms trading with one another on the basis of the gold standard do not have the intention of changing the size of their cash holdings. From their purchases and sales, claims are generated which necessitate interlocal payments. But according to our assumption these interlocal payments are equal in amount. The amount that the residents of A have to pay to the residents of B is equal to the amount that the residents of B have to pay to the residents of A. It is therefore possible to save the costs of shipping gold from A to B and from B to A. Claims and debts can be settled by a sort of interlocal clearing. It is merely a technical problem whether this evening up is effected by an interlocal clearing-house organization or by the turnovers of a special market for foreign Edition: current; Page: [454] exchange. At any rate, the price which a resident of A (or of B) has to pay for a payment due in B (or in A) is kept within the margins determined by the shipment costs. It cannot rise above the par value by more than the shipment costs (gold export point) and cannot fall below the shipment costs (gold import point).

It may happen that—all our other assumptions remaining unaltered—there is a temporal discrepancy between the payments due from A to B and those from B to A. Then an interlocal shipment of gold can only be avoided by the interposition of a credit transaction. If the importer who today has to pay from A to B can buy at the market of foreign exchange claims against residents of B as fall due in ninety days, he can save the costs of shipping gold by borrowing the sum concerned in B for a period of ninety days. The dealers in foreign exchange will resort to this makeshift if the costs of borrowing in B do not exceed the costs of borrowing in A by more than double the costs of shipping gold. If the cost of shipping gold is 1⁄8 per cent, they will be ready to pay for a three months’ loan in B up to 1 per cent (pro anno) more as interest than corresponds to the state of the money-market interest rate at which, in the absence of such requirements for interlocal payments, credit transactions between A and B would be effected.

It is permissible to express these facts by contending that the daily state of the balance of payments between A and B determines the point at which, within the margins drawn by the gold export point and the gold import point, the foreign exchange rates are fixed. But one must not forget to add that this happens only if the residents of A and of B do not intend to change the size of their cash holdings. Only because this is the case does it become possible to avoid the transfer of gold altogether and to keep foreign exchange rates within the limits drawn by the two gold points. If the residents of A want to reduce their cash holdings and those of B want to increase theirs, gold must be shipped from A to B until the rate for cable transfer B reaches in A the gold export point. Then gold is sent from A to B in the same way in which cotton is regularly sent from the United States to Europe. The rate of cable transfer B reaches the gold export point because the residents of A are selling gold to those of B, not because their balance of payments is unfavorable.

All this is valid with regard to any payments to be transacted between various places. It makes no difference whether the cities concerned belong to the same sovereign nation or to different sovereign nations. However, government interference has considerably changed the conditions. All governments have created institutions which make Edition: current; Page: [455] it possible for the residents of their countries to make interlocal domestic payments at par. The costs involved in shipment of currency from one place to another are borne either by the treasury or by the country’s central bank system or by another government bank such as the postal savings banks of various European countries. Thus there is no longer any market for domestic interlocal exchange. The public is not charged more for an interlocal order to pay than for a local one or, if the charge is slightly different, it no longer has any reference to the fluctuations of the interlocal movements of currency within the country. It is this government interference which has sharpened the difference between domestic payment and payment abroad. Domestic payments are transacted at par, while with regard to foreign payments fluctuations occur within the limits drawn by the gold points.

If more than one kind of money is used as medium of exchange, the mutual exchange ratio between them is determined by their purchasing power. The final prices of the various commodities, as expressed in each of the two or several kinds of money, are in proportion to each other. The final exchange ratio between the various kinds of money reflects their purchasing power with regard to the commodities. If any discrepancy appears, opportunity for profitable transactions presents itself and the endeavors of businessmen eager to take advantage of this opportunity tend to make it disappear again. The purchasing-power parity theory of foreign exchange is merely the application of the general theorems concerning the determination of prices to the special case of the coexistence of various kinds of money.

It does not matter whether the various kinds of money coexist in the same territory or whether their use is limited to distinct areas. In any case the mutual exchange ratio between them tends to a final state at which it no longer makes any difference whether one buys and sells against this or that kind of money. As far as costs of interlocal transfer come into play, these costs must be added or deducted.

The changes in purchasing power do not occur at the same time with regard to all commodities and services. Let us consider again the practically very important instance of an inflation in one country only. The increase in the quantity of domestic credit money or fiat money affects at first only the prices of some commodities and services. The prices of the other commodities remain for some time still at their previous stand. The exchange ratio between the domestic currency and the foreign currencies is determined on the bourse, a market organized and managed according to the pattern and the commercial customs of the stock exchange. The dealers on this special Edition: current; Page: [456] market are quicker than the rest of the people in anticipating future changes. Consequently the price structure of the market for foreign exchange reflects the new money relation sooner than the prices of many commodities and services. As soon as the domestic inflation begins to affect the prices of some commodities, at any rate long before it has exhausted all its effects upon the greater part of the prices of commodities and services, the price of foreign exchange tends to rise to the point corresponding to the final state of domestic prices and wage rates.

This fact has been entirely misinterpreted. People failed to realize that the rise in foreign exchange rates merely anticipates the movement of domestic commodity prices. They explained the boom in foreign exchange as an outcome of an unfavorable balance of payments. The demand for foreign exchange, they maintained, has been increased by a deterioration of the balance of trade or of other items of the balance of payments, or simply by sinister machinations on the part of unpatriotic speculators. The higher prices to be paid for foreign exchange cause the domestic prices of imported goods to rise. The prices of the domestic products must follow suit because otherwise their low state would encourage business to withhold them from domestic consumption and to sell them abroad at a premium.

The fallacies involved in this popular doctrine can easily be shown. If the nominal income of the domestic public had not been increased by the inflation, they would be forced to restrict their consumption either of imported or of domestic products. In the first case imports would drop and in the second case exports would increase. Thus the balance of trade would again be brought back to what the Mercantilists call a favorable state.

Pressed hard, the Mercantilists cannot help admitting the cogency of this reasoning. But, they say, it applies only to normal trade conditions. It does not take into account the state of affairs in countries which are under the necessity of importing vital commodities such as food and essential raw materials. The importation of such goods cannot be curtailed below a certain minimum. They are imported no matter what prices must be paid for them. If the foreign exchange required for importing them cannot be procured by an adequate amount of exports, the balance of trade becomes unfavorable and the foreign exchange rates must rise more and more.

This is no less illusory than all other Mercantilist ideas. However urgent and vital an individual’s or a group of individuals’ demand for some goods may be, they can satisfy it on the market only by paying the market price. If an Austrian wants to buy Canadian Edition: current; Page: [457] wheat, he must pay the market price in Canadian dollars. He must procure these Canadian dollars by exporting goods either directly to Canada or to some other country. He does not increase the amount of Canadian dollars available by paying higher prices (in schillings, the Austrian domestic currency) for Canadian dollars. Moreover, he cannot afford to pay such higher prices (in schillings) for imported wheat if his income (in schillings) remains unchanged. Only if the Austrian government embarks upon an inflationary policy and thus increases the number of schillings in the pockets of its citizens, are the Austrians in a position to continue to buy the quantities of Canadian wheat they used to buy without curtailing other expenditures. If there were no domestic inflation, any rise in the price of imported goods would result either in a drop in their consumption or in a restriction in the consumption of other goods. Thus the process of readjustment as described above would have come into motion.

If a man lacks the money to buy bread from his neighbor, the village baker, the cause is not to be seen in an alleged scarcity of money. The cause is that this man did not succeed in earning the amount of money needed either by selling goods or by rendering services for which people are prepared to pay. The same is true with regard to international trade. A country may be distressed on account of the fact that it is at a loss to sell abroad as many commodities as it would have to sell in order to buy all the food its citizens want. But this does not mean that foreign exchange is scarce. It means that the residents are poor. And domestic inflation is certainly not an appropriate means to remove this poverty.

Neither has speculation any reference to the determination of foreign exchange rates. The speculators merely anticipate the expected alterations. If they err, if their opinion that an inflation is in progress is wrong, the structure of prices and foreign exchange rates will not correspond to their anticipations and they will have to pay for their mistakes by losses.

The doctrine according to which foreign exchange rates are determined by the balance of payments is based upon an illicit generalization of a special case. If two places, A and B, use the same kind of money and if the residents do not want to make any changes in the size of their cash holdings, over a given period of time the amount of money paid from the residents of A to those of B equals the amount paid from the residents of B to those of A and all payments can be settled without shipping money from A to B or from B to A. Then the rate of cable transfer B in A cannot rise above a point slightly below the gold export point and cannot drop below a point slightly Edition: current; Page: [458] above the gold import point, and vice versa. Within this margin the daily state of the balance of payments determines the daily state of the foreign exchange rate. This is the case only because neither the residents of A nor those of B want to alter the amount of their cash holdings. If the residents of A want to decrease their cash holdings and those of B to increase theirs, money is shipped from A to B and the cable rate B reaches in A the gold export point. But money is not shipped because A’s balance of payments has become unfavorable. What is called by the Mercantilists an unfavorable balance of payments is the effect of a deliberate restriction of cash holdings on the part of the citizens of A and a deliberate increase in cash holdings on the part of the citizens of B. If no resident of A were ready to reduce his cash holding, such an outflow of money from A could never materialize.

The difference between the trade in money and that in the vendible commodities is this: As a rule commodities move on a one-way road, viz., from the places of surplus production to those of surplus consumption. Consequently the price of a certain commodity in the places of surplus production is as a rule lower by the amount of shipping costs than in the places of surplus consumption. Things are different with money if we do not take into account the conditions of the gold-mining countries and of those countries whose residents deliberately aim at altering the size of their cash holdings. Money moves now this way, now that. At one time a country exports money, at another time it imports money. Every exporting country very soon becomes an importing country precisely on account of its previous exports. For this reason alone it is possible to save the costs of shipping money by the interplay of the market for foreign exchange.

16: Interest Rates and the Money Relation

Money plays in credit transaction the same role it plays in all other business transactions. As a rule loans are granted in money, and interest and principal are paid in money. The payments resulting from such dealings influence the size of cash holding only temporarily. The recipients of loans, interest, and principal spend the sums received either for consumption or for investment. They increase their cash holdings only if definite considerations, independent of the inflow of the money received, motivate them to act in this way.

The final state of the market rate of interest is the same for all loans of the same character. Differences in the rate of interest are caused either by differences in the soundness and trustworthiness of Edition: current; Page: [459] the debtor or by differences in the terms of the contract.21 Differences in interest rates which are not brought about by these differences in conditions tend to disappear. The applicants for credits approach the lenders who ask a lower rate of interest. The lenders are eager to cater to people who are ready to pay higher interest rates. Things on the money market are the same as on all other markets.

With regard to interlocal credit transactions the interlocal exchange rates are to be taken into account as well as differences in the monetary standard if there are any. Let us contemplate the case of two countries, A and B. A is under the gold standard, B under the silver standard. The lender who considers lending money from A to B must first sell gold against silver and later, at the termination of the loan, silver against gold. If at that later date the price of silver has dropped as against gold, the principal repaid by the debtor (in silver) will buy a smaller amount of gold than that expended by the creditor when he previously embarked upon the transaction. He will therefore only venture lending in B if the difference in the market rate of interest between A and B is large enough to cover an expected fall in the price of silver as against gold. The tendency toward an equalization of the market rate of interest for short-term loans which prevails if A and B are both under the same monetary standard is seriously impaired under a diversity of standards.

If A and B are both under the same standard, it is impossible for the banks of A to expand credit if those of B do not espouse the same policy. Credit expansion in A makes prices rise, and short-term interest rates temporarily drop in A, while prices and interest rates in B remain unchanged. Consequently exports from A drop and imports to A increase. In addition, the money lenders of A become eager to lend on the short-term loan market of B. The result is an external drain from A which makes the money reserves of A’s banks dwindle. If the banks of A do not abandon their expansionist policy, they will become insolvent.

This process has been entirely misinterpreted. People speak of an important and vital function which a country’s central bank has to fulfill on behalf of the nation. It is, they say, the central bank’s sacred duty to preserve the stability of foreign exchange rates and to protect the nation’s gold reserve against attacks on the part of foreign speculators and their domestic abettors. The truth is that all that a central bank does lest its gold reserve evaporate is done for the sake of the preservation of its own solvency. It has jeopardized its financial position by embarking upon credit expansion and must now undo Edition: current; Page: [460] its previous action in order to avoid its disastrous consequences. Its expansionist policy has encountered the obstacles limiting the issuance of fiduciary media.

The use of the terminology of warfare is inappropriate in dealing with monetary matters, as it is in the treatment of all other catallactic problems. There is no such thing as a “war” between the central banks. No sinister forces are “attacking” a bank’s position and threatening the stability of foreign exchange rates. No “defender” is needed to “protect” a nation’s currency system. It is, moreover, not true that what prevent a nation’s central bank or its private banks from lowering the domestic market rate of interest are considerations of the preservation of the gold standard and of foreign exchange stability and of frustrating the machinations of an international combine of capitalistic money-lenders. The market rate of interest cannot be lowered by a credit expansion except for a short time, and even then it brings about all those effects which the theory of the trade cycle describes.

When the Bank of England redeemed a banknote issued according to the terms of the contract, it did not render unselfishly a vital service to the British people. It simply did what every housewife does in paying the grocer’s bill. The idea that there is some special merit in a central bank’s fulfillment of its voluntarily assumed responsibilities could originate only because again and again governments granted to these banks the privilege of denying to their clients the payments to which they had a legal title. In fact, the central banks became more and more subordinate offices of the treasuries, mere tools for the performance of credit expansion and inflation. It does not make any difference practically whether they are or are not owned by the government and directly managed by government officials. In effect the banks granting circulation credit are in every country today only affiliates of the treasuries.

There is but one means of keeping a local and national currency permanently at par with gold and foreign exchange: unconditional redemption. The central bank has to buy at the parity rate any amount of gold and foreign exchange offered against domestic banknotes and deposit currency; on the other hand it has to sell, without discrimination, any amount of gold and foreign exchange asked for by people ready to pay the parity price in domestic banknotes, coins, or deposit currency. Such was the policy of central banks under the gold standard. Such was also the policy of those governments and central banks which had adopted the currency system commonly known under the name of the gold exchange standard. The only difference between the “orthodox” or classical gold standard as it Edition: current; Page: [461] existed in Great Britain from the early ’twenties of the nineteenth century until the outbreak of the first World War and in other countries on the one hand, and the gold exchange standard on the other, concerned the use of gold coins on the domestic market. Under the classical gold standard a part of the cash holdings of the citizens consisted in gold coins and the rest in money substitutes. Under the gold exchange standard the cash holdings consisted entirely in money-substitutes.

Pegging a certain rate of foreign exchange is tantamount to redemption at this rate.

A foreign exchange equalization account, too, can succeed in its operations only as far as it clings to the same methods.

The reasons why in the last decades European governments have preferred foreign exchange equalization accounts to the operation of central banks are obvious. Central bank legislation was an achievement of liberal governments or of governments which did not dare to challenge openly, at least in the conduct of financial policies, public opinion of the liberal countries. The operations of central banks were therefore adjusted to economic freedom. For that reason they were considered unsatisfactory in this age of rising totalitarianism. The main characteristics of the operation of a foreign exchange equalization account as distinguished from central bank policy are:

1. The authorities keep the transactions of the account secret. The laws have obliged the central banks to publicize their actual status at short intervals, as a rule every week. But the status of the foreign exchange equalization accounts is known only to the initiated. Officialdom renders a report to the public only after a lapse of time when the figures are of interest to historians alone and of no use whatever to the businessman.

2. This secrecy makes it possible to discriminate against people not in great favor with the authorities. In many continental countries of Europe it resulted in scandalous corruption. Other governments used the power to discriminate to the detriment of businessmen belonging to linguistic or religious minorities or supporting opposition parties.

3. A parity is no longer fixed by a law duly promulgated by parliament and therefore known to every citizen. The determination depends upon the arbitrariness of bureaucrats. From time to time the newspapers reported: The Ruritanian currency is weak. A more correct description would have been: The Ruritanian authorities have decided to raise the price of foreign exchange.22

A foreign exchange equalization account is not a magic wand for Edition: current; Page: [462] remedying the evils of inflation. It cannot apply any means other than those available to “orthodox” central banks. And it must, like the central banks, fail in the endeavors to keep foreign exchange rates at par if there is domestic inflation and credit expansion.

It has been asserted that the “orthodox” methods of fighting an external drain by using the rate of discount no longer work because nations are no longer prepared to comply with “the rules of the game.” Now, the gold standard is not a game, but a social institution. Its working does not depend on the preparedness of any people to observe some arbitrary rules. It is controlled by the operation of inexorable economic law.

The critics give point to their objection by citing the fact that in the interwar period a rise in the rate of discount failed to stop the external drain, i.e., the outflow of specie and the transfer of deposits into foreign countries. But this phenomenon was caused by the governments’ anti-gold and pro-inflation policies. If a man expects that he will lose 40 per cent of his balance by an impending devaluation, he will try to transfer his deposit into another country and will not change his mind if the bank rate in the country planning a devaluation rises 1 or 2 per cent. Such a rise in the rate of discount is obviously not a compensation for a loss ten or twenty or even forty times greater. Of course, the gold standard cannot work if governments are eager to sabotage its operations.

17: Secondary Media of Exchange

The use of money does not remove the differences which exist between the various nonmonetary goods with regard to their marketability. In the money economy there is a very substantial difference between the marketability of money and that of the vendible goods. But there remain differences between the various specimens of this latter group. For some of them it is easier to find without delay a buyer ready to pay the highest price which, under the state of the market, can possibly be attained. With others it is more difficult. A first-class bond is more marketable than a house in a city’s main street, and an old fur coat is more marketable than an autograph of an eighteenth-century statesman. One no longer compares the marketability of the various vendible goods with the perfect marketability of money. One merely compares the degree of marketability of the various commodities. One may speak of the secondary marketability of the vendible goods.

He who owns a stock of goods of a high degree of secondary marketability is in a position to restrict his cash holding. He can expect that when one day it is necessary for him to increase his cash holding Edition: current; Page: [463] he will be in a position to sell these goods of a high degree of secondary marketability without delay at the highest price attainable at the market. Thus the size of a man’s or a firm’s cash holding is influenced by whether or not he owns a stock of goods with a high degree of secondary marketability. The size of cash holding and the expense incurred in keeping it can be reduced if income-producing goods of a high degree of secondary marketability are available.

Consequently there emerges a specific demand for such goods on the part of people eager to keep them in order to reduce the costs of cash holding. The prices of these goods are partly determined by this specific demand; they would be lower in its absence. These goods are secondary media of exchange, as it were, and their exchange value is the resultant of two kinds of demand: the demand related to their services as secondary media of exchange, and the demand related to the other services they render.

The costs incurred by holding cash are equal to the amount of interest which the sum concerned would have borne when invested. The cost incurred by holding a stock of secondary media of exchange consists in the difference between the interest yield of the securities employed for this purpose and the higher yield of other securities which differ from the former only in regard to their lower marketability and are therefore not suited for the role of secondary media of exchange.

From time immemorial jewels have been used as secondary media of exchange. Today the secondary media of exchange commonly used are:

1. Claims against banks, bankers, and savings banks which—although not money-substitutes23—are daily maturing or can be withdrawn on short notice.

2. Bonds whose volume and popularity are so great that it is, as a rule, possible to sell moderate quantities of them without depressing the market.

Of course, the advantages to be expected from lowering the costs of holding cash must be confronted with certain hazards incurred. The sale of securities and still more that of commodities may only be feasible with a loss. This danger is not present with bank balances and the hazard of the bank’s insolvency is usually negligible. Therefore interest-bearing claims against banks and bankers, which can be withdrawn at short notice, are the most popular secondary media of exchange.

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One must not confuse secondary media of exchange with money-substitutes. Money-substitutes are in the settlement of payments given away and received like money. But the secondary media of exchange must first be exchanged against money or money-substitutes if one wants to use them—in a roundabout way—for paying or for increasing cash holdings.

Claims employed as secondary media of exchange have, because of this employment, a broader market and a higher price. The outcome of this is that they yield lower interest than claims of the same kind which are not fit to serve as secondary media of exchange. Government bonds and treasury bills which can be used as secondary media of exchange can be floated on conditions more favorable to the debtor than loans not suitable for this purpose. The debtors concerned are therefore eager to organize the market for their certificates of indebtedness in such a way as to make them attractive for those in search of secondary media of exchange. They are intent upon making it possible for every holder of such securities to sell them or to use them as collateral in borrowing under the most reasonable terms. In advertising their bond issues to the public they stress these opportunities as a special boon.

In the same way, banks and bankers are intent upon attracting demand for secondary media of exchange. They offer convenient terms to their customers. They try to outdo one another by shortening the time allowed for notice. Sometimes they pay interest even for money maturing without notice. In this rivalry some banks have gone too far and endangered their solvency.

Political conditions of the last decades have given to bank balances which can be used as secondary media of exchange an increased importance. The governments of almost all countries are engaged in a campaign against the capitalists. They are intent upon expropriating them by means of taxation and monetary measures. The capitalists are eager to protect their property by keeping a part of their funds liquid in order to evade confisca-tory measures in time. They keep balances with the banks of those countries in which the danger of confiscation or currency devaluation is for the moment less than in other countries. As soon as the prospects change, they transfer their balances into countries which temporarily seem to offer more security. It is these funds which people have in mind when speaking of “hot money.”

The significance of hot money for the constellation of monetary affairs is the outcome of the one-reserve system. In order to make it easier for the central banks to embark upon credit expansion, the European governments aimed long ago at a concentration of their Edition: current; Page: [465] countries’ gold reserves with the central banks. The other banks (the private banks, i.e., those not endowed with special privileges and not entitled to issue banknotes) restrict their cash holdings to the requirements of their daily transactions. They no longer keep a reserve against their daily maturing liabilities. They do not consider it necessary to balance the maturity dates of their liabilities and their assets in such a way as to be any day ready to comply unaided with their obligations to their creditors. They rely upon the central bank. When the creditors want to withdraw more than the “normal” amount, the private banks borrow the funds needed from the central bank. A private bank considers itself liquid if it owns a sufficient amount either of collateral against which the central bank will lend or of bills of exchange which the central bank will rediscount.24

When the inflow of hot money began, the private banks of the countries in which it was temporarily deposited saw nothing wrong in treating these funds in the usual way. They employed the additional funds entrusted to them in increasing their loans to business. They did not worry about the consequences, although they knew that these funds would be withdrawn as soon as any doubts about their country’s fiscal or monetary policy emerged. The illiquidity of the status of these banks was manifest: on the one hand large sums which the customers had the right to withdraw at short notice, and on the other hand loans to business which could be recovered only at a later date. The only cautious method of dealing with hot money would have been to keep a reserve of gold and foreign exchange big enough to pay back the whole amount in case of a sudden withdrawal. Of course, this method would have required the banks to charge the customers a commission for keeping their funds safe.

The showdown came for the Swiss banks on the day in September, 1936, on which France devalued the French franc. The depositors of hot money became frightened; they feared that Switzerland might follow the French example. It was to be expected that they would all try to transfer their funds immediately to London or New York, or even to Paris, which for the immediate coming weeks seemed to offer a smaller hazard of currency depreciation. But the Swiss commercial banks were not in a position to pay back these funds without the aid of the National Bank. They had lent them to business—a great part to business in countries which, by foreign exchange control, had blocked their balances. The only way out would have been for them to borrow from the National Bank. Then they would have maintained their own solvency. But the depositors paid would have immediately Edition: current; Page: [466] asked the National Bank for the redemption, in gold or foreign exchange, of the banknotes received. If the National Bank were not to comply with this request, it would thereby have actually abandoned the gold standard and devalued the Swiss franc. If, on the other hand, the Bank had redeemed the notes, it would have lost the greater part of its reserve. A panic would have resulted. The Swiss themselves would have tried to procure as much gold and foreign exchange as possible. The whole monetary system of the country would have collapsed.

The only alternative for the Swiss National Bank would have been not to assist the private banks at all. But this would have been equivalent to the insolvency of the country’s most important credit institutions.

Thus for the Swiss government no choice was left. It had only one means to prevent an economic catastrophe: to follow suit forthwith and to devalue the Swiss franc. The matter did not brook delay.

By and large, Great Britain, at the outbreak of the war in September, 1939, had to face similar conditions. The City of London was once the world’s banking center. It has long since lost this function. But foreigners and citizens of the Dominions still kept, on the eve of the war, considerable short-term balances in the British banks. Besides, there were the large deposits due to the central banks in the “sterling area.” If the British government had not frozen all these balances by means of foreign exchange restrictions, the insolvency of the British banks would have become manifest. Foreign exchange control was a disguised moratorium for the banks. It relieved them from the plight of having to confess publicly their inability to fulfill their obligations.

18: The Inflationist View of History

A very popular doctrine maintains that progressive lowering of the monetary unit’s purchasing power played a decisive role in historical evolution. It is asserted that mankind would not have reached its present state of wellbeing if the supply of money had not increased to a greater extent than the demand for money. The resulting fall in purchasing power, it is said, was a necessary condition of economic progress. The intensification of the division of labor and the continuous growth of capital accumulation, which have centupled the productivity of labor, could ensue only in a world of progressive price rises. Inflation creates prosperity and wealth; deflation creates distress and economic decay.25 A survey of political literature and of the Edition: current; Page: [467] ideas that guided for centuries the monetary and credit policies of the nations reveals that this opinion is almost generally accepted. In spite of all warnings on the part of economists it is still today the core of the layman’s economic philosophy. It is no less the essence of the teachings of Lord Keynes and his disciples in both hemispheres.

The popularity of inflationism is in great part due to deep-rooted hatred of creditors. Inflation is considered just because it favors debtors at the expense of creditors. However, the inflationist view of history which we have to deal with in this section is only loosely related to this anticreditor argument. Its assertion that “expansionism” is the driving force of economic progress and that “restrictionism” is the worst of all evils is mainly based on other arguments.

It is obvious that the problems raised by the inflationist doctrine cannot be solved by a recourse to the teachings of historical experience. It is beyond doubt that the history of prices shows, by and large, a continuous, although sometimes for short periods interrupted, upward trend. It is of course impossible to establish this fact otherwise than by historical understanding. Catallactic precision cannot be applied to historical problems. The endeavors of some historians and statisticians to trace back the changes in the purchasing power of the precious metals for centuries, and to measure them, are futile. It has been shown already that all attempts to measure economic magnitudes are based on entirely fallacious assumptions and display ignorance of the fundamental principles both of economics and of history. But what history by means of its specific methods can tell us in this field is enough to justify the assertion that the purchasing power of money has for centuries shown a tendency to fall. With regard to this point all people agree.

But this is not the problem to be elucidated. The question is whether the fall in purchasing power was or was not an indispensable factor in the evolution which led from the poverty of ages gone by to the more satisfactory conditions of modern Western capitalism. This question must be answered without reference to the historical experience, which can be and always is interpreted in different ways, and to which supporters and adversaries of every theory and of every explanation of history refer as a proof of their mutually contradictory and incompatible statements. What is needed is a clarification of the effects of changes in purchasing power on the division of labor, the accumulation of capital, and technological improvement.

In dealing with this problem one cannot satisfy oneself with the refutation of the arguments advanced by the inflationists in support of their thesis. The absurdity of these arguments is so manifest that their refutation and exposure is easy indeed. From its very beginnings Edition: current; Page: [468] economics has shown again and again that assertions concerning the alleged blessings of an abundance of money and the alleged disasters of a scarcity of money are the outcome of crass errors in reasoning. The endeavors of the apostles of inflationism and expansionism to refute the correctness of the economists’ teachings have failed utterly.

The only relevant question is this: Is it possible or not to lower the rate of interest lastingly by means of credit expansion? This problem will be treated exhaustively in the chapter dealing with the interconnection between the money relation and the rate of interest. There it will be shown what the consequences of booms created by credit expansion must be.

But we must ask ourselves at this point of our inquiries whether it is not possible that there are other reasons which could be advanced in favor of the inflationary interpretation of history. Is it not possible that the champions of inflationism have neglected to resort to some valid arguments which could support their stand? It is certainly necessary to approach the issue from every possible avenue.

Let us think of a world in which the quantity of money is rigid. At an early stage of history the inhabitants of this world have produced the whole quantity of the commodity employed for the monetary service which can possibly be produced. A further increase in the quantity of money is out of the question. Fiduciary media are unknown. All money-substitutes—the subsidiary coins included—are money-certificates.

On these assumptions the intensification of the division of labor, the evolution from the economic self-sufficiency of households, villages, districts, and countries to the world-embracing market system of the nineteenth century, the progressive accumulation of capital, and the improvement of technological methods of production would have resulted in a continuous trend toward falling prices. Would such a rise in the purchasing power of the monetary unit have stopped the evolution of capitalism?

The average businessman will answer this question in the affirmative. Living and acting in an environment in which a slow but continuous fall in the monetary unit’s purchasing power is deemed normal, necessary, and beneficial, he simply cannot comprehend a different state of affairs. He associates the notions of rising prices and profits on the one hand and of falling prices and losses on the other. The fact that there are bear operations too and that great fortunes have been made by bears does not shake his dogmatism. These are, he says, merely speculative transactions of people eager to profit from the fall in the prices of goods already produced and available. Creative innovations, new investments, and the application of improved technological methods require the inducement brought about by the expectation of price rises. Economic progress is possible only in a world of rising prices.

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This opinion is untenable. In a world of a rising purchasing power of the monetary unit everybody’s mode of thinking would have adjusted itself to this state of affairs, just as in our actual world it has adjusted itself to a falling purchasing power of the monetary unit. Today everybody is prepared to consider a rise in his nominal or monetary income as an improvement of his material well-being. People’s attention is directed more toward the rise in nominal wage rates and the money equivalent of wealth than to the increase in the supply of commodities. In a world of rising purchasing power for the monetary unit they would concern themselves more with the fall in living costs. This would bring into clearer relief the fact that economic progress consists primarily in making the amenities of life more easily accessible.

In the conduct of business, reflections concerning the secular trend of prices do not play any role whatever. Entrepreneurs and investors do not bother about secular trends. What guides their actions is their opinion about the movement of prices in the coming weeks, months, or at most years. They do not heed the general movement of all prices. What matters for them is the existence of discrepancies between the prices of the complementary factors of production and the anticipated prices of the products. No businessman embarks upon a definite production project because he believes that the prices, i.e., the prices of all goods and services, will rise. He engages himself if he believes that he can profit from a difference between the prices of goods of various orders. In a world with a secular tendency toward falling prices, such opportunities for earning profit will appear in the same way in which they appear in a world with a secular trend toward rising prices. The expectation of a general progressive upward movement of all prices does not bring about intensified production and improvement in well-being. It results in the “flight to real values,” in the crack-up boom and the complete breakdown of the monetary system.

If the opinion that the prices of all commodities will drop becomes general, the short-term market rate of interest is lowered by the amount of the negative price premium.26 Thus the entrepreneur employing borrowed funds is secured against the consequences of such a drop in prices to the same extent to which, under conditions of rising prices, the lender is secured through the price premium against the consequences of falling purchasing power.

A secular tendency toward a rise in the monetary unit’s purchasing power would require rules of thumb on the part of businessmen and investors other than those developed under the secular tendency toward a fall in its purchasing power. But it would certainly not influence substantially the course of Edition: current; Page: [470] economic affairs. It would not remove the urge of people to improve their material well-being as far as possible by an appropriate arrangement of production. It would not deprive the economic system of the factors making for material improvement, namely, the striving of enterprising promoters after profit and the readiness of the public to buy those commodities which are apt to provide them the greatest satisfaction at the lowest costs.

Such observations are certainly not a plea for a policy of deflation. They imply merely a refutation of the ineradicable inflationist fables. They unmask the illusiveness of Lord Keynes’s doctrine that the source of poverty and distress, of depression of trade, and of unemployment is to be seen in a “contractionist pressure.” It is not true that “a deflationary pressure . . . would have . . . prevented the development of modern industry.” It is not true that credit expansion brings about the “miracle . . . of turning a stone into bread.”27

Economics recommends neither inflationary nor deflationary policy. It does not urge the governments to tamper with the market’s choice of a medium of exchange. It establishes only the following truths:

1. By committing itself to an inflationary or deflationary policy a government does not promote the public welfare, the commonweal, or the interests of the whole nation. It merely favors one or several groups of the population at the expense of other groups.

2. It is impossible to know in advance which group will be favored by a definite inflationary or deflationary measure and to what extent. These effects depend on the whole complex of the market data involved. They also depend largely on the speed of the inflationary or deflationary movements and may be completely reversed with the progress of these movements.

3. At any rate, a monetary expansion results in misinvestment of capital and overconsumption. It leaves the nation as a whole poorer, not richer. These problems are dealt with in Chapter 20.

4. Continued inflation must finally end in the crack-up boom, the complete breakdown of the currency system.

5. Deflationary policy is costly for the treasury and unpopular with the masses. But inflationary policy is a boon for the treasury and very popular with the ignorant. Practically, the danger of deflation is but slight and the danger of inflation tremendous.

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19: The Gold Standard

Men have chosen the precious metals gold and silver for the money service on account of their mineralogical, physical, and chemical features. The use of money in a market economy is a praxeologically necessary fact. That gold—and not something else—is used as money is merely a historical fact and as such cannot be conceived by catallactics. In monetary history too, as in all other branches of history, one must resort to historical understanding. If one takes pleasure in calling the gold standard a “barbarous relic,”28 one cannot object to the application of the same term to every historically determined institution. Then the fact that the British speak English—and not Danish, German, or French—is a barbarous relic too, and every Briton who opposes the substitution of Esperanto for English is no less dogmatic and orthodox than those who do not wax rapturous about the plans for a managed currency.

The demonetization of silver and the establishment of gold monometallism was the outcome of deliberate government interference with monetary matters. It is pointless to raise the question concerning what would have happened in the absence of these policies. But it must not be forgotten that it was not the intention of the governments to establish the gold standard. What the governments aimed at was the double standard. They wanted to substitute a rigid, government-decreed exchange ratio between gold and silver for the fluctuating market ratios between the independently coexistent gold and silver coins. The monetary doctrines underlying these endeavors misconstrued the market phenomena in that complete way in which only bureaucrats can misconstrue them. The attempts to create a double standard of both metals, gold and silver, failed lamentably. It was this failure which generated the gold standard. The emergence of the gold standard was the manifestation of a crushing defeat of the governments and their cherished doctrines.

In the seventeenth century the rates at which the English government tariffed the coins overvalued the guinea with regard to silver and thus made the silver coins disappear. Only those silver coins which were much worn by usage or in any other way defaced or reduced in weight remained in current use; it did not pay to export and to sell them on the bullion market. Thus England got the gold standard against the intention of its government. Only much later the laws made the de facto [actual] gold standard a de jure [legal] standard. The government abandoned further fruitless attempts to pump silver sta ndard coins into the market and minted silver only as subsidiary coins with a limited legal tender power. These subsidiary Edition: current; Page: [472] coins were not money, but money-substitutes. Their exchange value depended not on their silver content, but on the fact that they could be exchanged at every instant, without delay and without cost, at their full face value against gold. They were de facto silver printed notes, claims against a definite amount of gold.

Later in the course of the nineteenth century the double standard resulted in a similar way in France and in the other countries of the Latin Monetary Union in the emergence of de facto gold monometallism. When the drop in the price of silver in the later ’seventies would automatically have effected the replacement of the de facto gold standard by the de facto silver standard, these governments suspended the coinage of silver in order to preserve the gold standard. In the United States the price structure on the bullion market had already, before the outbreak of the Civil War, transformed the legal bimetallism into de facto gold monometallism. After the greenback period there ensued a struggle between the friends of the gold standard on the one hand and those of silver on the other hand. The result was a victory for the gold standard. Once the economically most advanced nations had adopted the gold standard, all other nations followed suit. After the great inflationary adventures of the first World War most countries hastened to return to the gold standard or the gold exchange standard.

The gold standard was the world standard of the age of capitalism, increasing welfare, liberty, and democracy, both political and economic. In the eyes of the free traders its main eminence was precisely the fact that it was an international standard as required by international trade and the transactions of the international money and capital market.29 It was the medium of exchange by means of which Western industrialism and Western capital had borne Western civilization into the remotest parts of the earth’s surface, everywhere destroying the fetters of age-old prejudices and superstitions, sowing the seeds of new life and new well-being, freeing minds and souls, and creating riches unheard of before. It accompanied the triumphal unprecedented progress of Western liberalism ready to unite all nations into a community of free nations peacefully cooperating with one another.

It is easy to understand why people viewed the gold standard as the symbol of this greatest and most beneficial of all historical changes. All those intent upon sabotaging the evolution toward welfare, peace, freedom, and democracy loathed the gold standard, and not only on account of its economic significance. In their eyes the gold standard was the labarum [(Latin) derived from the Roman, or Imperial, standard or symbol for which men live or die], Edition: current; Page: [473] the symbol, of all those doctrines and policies they wanted to destroy. In the struggle against the gold standard much more was at stake than commodity prices and foreign exchange rates.

The nationalists are fighting the gold standard because they want to sever their countries from the world market and to establish national autarky as far as possible. Interventionist governments and pressure groups are fighting the gold standard because they consider it the most serious obstacle to their endeavors to manipulate prices and wage rates. But the most fanatical attacks against gold are made by those intent upon credit expansion. With them credit expansion is the panacea for all economic ills. It could lower or even entirely abolish interest rates, raise wages and prices for the benefit of all except the parasitic capitalists and the exploiting employers, free the state from the necessity of balancing its budget—in short, make all decent people prosperous and happy. Only the gold standard, that devilish contrivance of the wicked and stupid “orthodox” economists, prevents mankind from attaining everlasting prosperity.

The gold standard is certainly not a perfect or ideal standard. There is no such thing as perfection in human things. But nobody is in a position to tell us how something more satisfactory could be put in place of the gold standard. The purchasing power of gold is not stable. But the very notions of stability and unchangeability of purchasing power are absurd. In a living and changing world there cannot be any such thing as stability of purchasing power. In the imaginary construction of an evenly rotating economy there is no room left for a medium of exchange. It is an essential feature of money that its purchasing power is changing. In fact, the adversaries of the gold standard do not want to make money’s purchasing power stable. They want rather to give to the governments the power to manipulate purchasing power without being hindered by an “external” factor, namely, the money relation of the gold standard.

The main objection raised against the gold standard is that it makes operative in the determination of prices a factor which no government can control—the vicissitudes of gold production. Thus an “external” or “automatic” force restrains a national government’s power to make its subjects as prosperous as it would like to make them. The international capitalists dictate and the nation’s sovereignty becomes a sham.

However, the futility of interventionist policies has nothing at all to do with monetary matters. It will be shown later why all isolated measures of government interference with market phenomena must fail to attain the ends sought. If the interventionist government wants to remedy the shortcomings of its first interferences by going further and further, it finally converts its country’s economic system into socialism of the German pattern. Then it abolishes the domestic Edition: current; Page: [474] market altogether, and with it money and all monetary problems, even though it may retain some of the terms and labels of the market economy.30 In both cases it is not the gold standard that frustrates the good intentions of the benevolent authority.

The significance of the fact that the gold standard makes the increase in the supply of gold depend upon the profitability of producing gold is, of course, that it limits the government’s power to resort to inflation. The gold standard makes the determination of money’s purchasing power independent of the changing ambitions and doctrines of political parties and pressure groups. This is not a defect of the gold standard; it is its main excellence. Every method of manipulating purchasing power is by necessity arbitrary. All methods recommended for the discovery of an allegedly objective and “scientific” yardstick for monetary manipulation are based on the illusion that changes in purchasing power can be “measured.” The gold standard removes the determination of cash-induced changes in purchasing power from the political arena. Its general acceptance requires the acknowledgment of the truth that one cannot make all people richer by printing money. The abhorrence of the gold standard is inspired by the superstition that omnipotent governments can create wealth out of little scraps of paper.

It has been asserted that the gold standard too is a manipulated standard. The governments may influence the height of gold’s purchasing power either by credit expansion, even if it is kept within the limits drawn by considerations of preserving the redeemability of the money-substitutes, or indirectly by furthering measures which induce people to restrict the size of their cash holdings. This is true. It cannot be denied that the rise in commodity prices which occurred between 1896 and 1914 was to a great extent provoked by such government policies. But the main thing is that the gold standard keeps all such endeavors toward lowering money’s purchasing power within narrow limits. The inflationists are fighting the gold standard precisely because they consider these limits a serious obstacle to the realization of their plans.

What the expansionists call the defects of the gold standard are indeed its very eminence and usefulness. It checks large-scale inflationary ventures on the part of governments. The gold standard did not fail. The governments were eager to destroy it, because they were committed to the fallacies that credit expansion is an appropriate means of lowering the rate of interest and of “improving” the balance of trade.

No government is, however, powerful enough to abolish the gold standard. Gold is the money of international trade and of the supernational economic Edition: current; Page: [475] community of mankind. It cannot be affected by measures of governments whose sovereignty is limited to definite countries. As long as a country is not economically self-sufficient in the strict sense of the term, as long as there are still some loopholes left in the walls by which national governments try to isolate their countries from the rest of the world, gold is still used as money. It does not matter that governments confiscate the gold coins and bullion they can seize and punish those holding gold as felons.* The language of bilateral clearing agreements by means of which governments are intent upon eliminating gold from international trade, avoids any reference to gold. But the turnovers performed on the ground of those agreements are calculated on gold prices. He who buys or sells on a foreign market calculates the advantages and disadvantages of such transactions in gold. In spite of the fact that a country has severed its local currency from any link with gold, its domestic structure of prices remains closely connected with gold and the gold prices of the world market. If a government wants to sever its domestic prices structure from that of the world market, it must resort to other measures, such as prohibitive import and export duties and embargoes. Nationalization of foreign trade, whether effected openly or directly by foreign exchange control, does not eliminate gold. The governments qua traders are trading by the use of gold as a medium of exchange.

The struggle against gold which is one of the main concerns of all contemporary governments must not be looked upon as an isolated phenomenon. It is but one item in the gigantic process of destruction which is the mark of our time. People fight the gold standard because they want to substitute national autarky for free trade, war for peace, totalitarian government omnipotence for liberty.

It may happen one day that technology will discover a method of enlarging the supply of gold at such a low cost that gold will become useless for the monetary service. Then people will have to replace the gold standard by another standard. It is futile to bother today about the way in which this problem will be solved. We do not know anything about the conditions under which the decision will have to be made.

International Monetary Cooperation

The international gold standard works without any action on the part of governments. It is effective real cooperation of all members of the world-embracing market economy. There is no need for any government to interfere in order to make the gold standard work as an international standard.

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What governments call international monetary cooperation is concerted action for the sake of credit expansion. They have learned that credit expansion, when limited to one country only, results in an external drain. They believe that it is only the external drain that frustrates their plans of lowering the rate of interest and thus of creating an everlasting boom. If all governments were to cooperate in their expansionist policies, they think, they could remove this obstacle. What is required is an international bank issuing fiduciary media which are dealt with as money-substitutes by all people in all countries.

There is no need to stress again here the point that what makes it impossible to lower the rate of interest by means of credit expansion is not merely the external drain. This fundamental issue is dealt with exhaustively in other chapters and sections of this book.31

But there is another important question to be raised.

Let us assume that there exists an international bank issuing fiduciary media the clientele of which is the world’s whole population. It does not matter whether these money-substitutes go directly into the cash holdings of the individuals and firms, or are only kept by the various nations’ central banks as reserves against the issuance of national money-substitutes. The deciding point is that there is a uniform world currency. The national banknotes and checkbook money are redeemable in money-substitutes issued by the international bank. The necessity of keeping its national currency at par with the international currency limits the power of every nation’s central banking system to expand credit. But the world bank is restrained only by those factors which limit credit expansion on the part of a single bank operating in an isolated economic system or in the whole world.

We may as well assume that the international bank is not a bank issuing money-substitutes, a part of which are fiduciary media, but a world authority issuing international fiat money. Gold has been entirely demonetized. The only money in use is that created by the international authority. The international authority is free to increase the quantity of this money provided it does not go so far as to bring about the crack-up boom and the breakdown of the currency.

Then the ideal of the Keynesians is realized. There is an institution operating which can exercise an “expansionist pressure on world trade.”

However, the champions of such plans have neglected a fundamental problem, namely, that of the distribution of the additional quantities of this credit money or of this paper money.

Let us assume that the international authority increases the amount of its issuance by a definite sum, all of which goes to one country, Ruritania. The final result of this inflationary action will be a rise in prices of commodities and services all over the world. But while this process is going on, the conditions of the citizens of various countries are affected in a different way. The Edition: current; Page: [477] Ruritanians are the first group blessed by the additional manna. They have more money in their pockets while the rest of the world’s inhabitants have not yet got a share of the new money. They can bid higher prices, while the others cannot. Therefore the Ruritanians withdraw more goods from the world market than they did before. The non-Ruritanians are forced to restrict their consumption because they cannot compete with the higher prices paid by the Ruritanians. While the process of adjusting prices to the altered money relation is still in progress, the Ruritanians are in an advantageous position against the non-Ruritanians. When the process finally comes to an end, the Ruritanians have been enriched at the expense of the non-Ruritanians.

The main problem in such expansionist ventures is the proportion according to which the additional money is to be allotted to the various nations. Each nation will be eager to advocate a mode of distribution which will give it the greatest possible share in the additional currency. The industrially backward nations of the East will, for instance, probably recommend equal distribution per capita of population, a mode which would obviously favor them at the expense of the industrially advanced nations. Whatever mode may be adopted, all nations would be dissatisfied and would complain of unfair treatment. Serious conflicts would ensue and would disrupt the whole scheme.

It would be irrelevant to object that this problem did not play an important role in the negotiations which preceded the establishment of the International Monetary Fund and that it was easy to reach an agreement concerning the use of the Fund’s resources. The Bretton Woods Conference was held under very particular circumstances. Most of the participating nations were at that time entirely dependent on the benevolence of the United States. They would have been doomed if the United States had stopped fighting for their freedom and aiding them materially by lend-lease.* The government of the United States, on the other hand, looked upon the monetary agreement as a scheme for a disguised continuation of lend-lease after the cessation of hostilities. The United States was ready to give and the other participants—especially those of the European countries, most of them at that time still occupied by the German armies, and those of the Asiatic countries—were ready to take whatever was offered to them. The problems involved will become discernible once the delusive attitude of the United States toward financial and trade matters is replaced by a more realistic mentality.

The International Monetary Fund did not achieve what its sponsors had expected. At the annual meetings of the Fund there is a good deal of discussion, and occasionally pertinent observations and criticisms concerning the monetary and credit policies of governments and central banks are brought forward. The Fund itself engages in lending and borrowing transactions with various Edition: current; Page: [478] governments and central banks. It considers its main function to be that of assisting governments to maintain an unrealistic exchange rate for their overexpanded national currency. The methods it resorts to in these endeavors do not differ essentially from those always applied for this purpose. Monetary affairs in the world are going on as if no Bretton Woods Agreement and no International Monetary Fund existed.

The constellation of the world’s political and economic affairs enabled the American government to keep its promise of letting foreign governments and central banks get an ounce of gold by paying thirty-five dollars.* But the continuation and intensification of the American “expansionist” policy has considerably increased the withdrawal of gold and makes people worry about the future of monetary conditions. They are frightened by the spectre of a farther increase in the demand for gold that may exhaust the gold funds of the United States and force it to abandon its present methods of dealing with gold.

The characteristic feature of the public discussion of the problems involved is that it carefully avoids mentioning the facts that are causing the extension of the demand for gold. No reference is made to the policies of deficit spending and credit expansion. Instead, complaints are raised about something called “insufficient liquidity” and a shortage of “reserves.” The remedy suggested is more liquidity, to be achieved by “creating” new additional “reserves.” This means it is proposed to cure the effects of inflation by more inflation.

There is need to remember that the policies of the American government and the Bank of England of maintaining on the London gold market a price of 35 dollars for an ounce of gold is the only measure that today prevents the Western nations from embarking upon boundless inflation. These policies are not immediately affected by the size of the various nations’ “reserves.” The plans for new “reserves” seem therefore not to concern directly the problem of the relation of gold to the dollar. They concern it indirectly as they try to divert the public’s attention from the real problem, inflation. For the rest, the official doctrine relies upon the long since discredited balance-of-payments interpretation of monetary troubles.

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CHAPTER 18: Action in the Passing of Time

1: Perspective in the Valuation of Time Periods

Acting man distinguishes the time before satisfaction of a want is attained and the time for which the satisfaction continues.

Action always aims at the removal of future uneasiness, be it only the future of the impending instant. Between the setting in of action and the attainment of the end sought there always elapses a fraction of time, viz., the maturing time in which the seed sown by the action grows to maturity. The most obvious example is provided by agriculture. Between the tilling of the soil and the ripening of the fruit there passes a considerable period of time. Another example is the improvement of the quality of wine by aging. In some cases, however, the maturing time is so short that ordinary speech may assert that the success appears instantly.

As far as action requires the employment of labor, it is concerned with the working time. The performance of every kind of labor absorbs time. In some cases the working time is so short that people say the performance requires no time at all.

Only in rare cases does a simple, indivisible and nonrepeated act suffice to attain the end aimed at. As a rule what separates the actor from the goal of his endeavors is more than one step only. He must make many steps. And every further step to be added to those previously made raises anew the question whether or not he should continue marching toward the goal once chosen. Most goals are so far away that only determined persistence leads to them. Persevering action, unflinchingly directed to the end sought, is needed in order to succeed. The total expenditure of time required, i.e., working time plus maturing time, may be called the period of production. The period of production is long in some cases and short in other cases. It is sometimes so short that it can be entirely neglected in practice.

The increment in want-satisfaction which the attainment of the end brings about is temporally limited. The result produced extends services only over a period of time which we may call the duration of serviceableness. The duration of serviceableness is shorter with Edition: current; Page: [480] some products and longer with other goods which are commonly called durable goods. Hence acting man must always take into account the period of production and the duration of serviceableness of the product. In estimating the disutility of a project considered he is not only concerned with the expenditure of material factors and labor required, but also with the period of production. In estimating the utility of the expected product he is concerned with the duration of its serviceableness. Of course, the more durable a product is, the greater is the amount of services it renders. But if these services are not cumulatively available on the same date, but extended piecemeal over a certain period of time, the time element, as will be shown, plays a particular role in their evaluation. It makes a difference whether n units of service are rendered on the same date or whether they are stretched over a period of n days in such a way that only one unit is available daily.

It is important to realize that the period of production as well as the duration of serviceableness are categories of human action and not concepts constructed by philosophers, economists, and historians as mental tools for their interpretation of events. They are essential elements present in every act of reasoning that precedes and directs action. It is necessary to stress this point because Böhm-Bawerk, to whom economics owes the discovery of the role played by the period of production, failed to comprehend the difference.

Acting man does not look at his condition with the eyes of a historian. He is not concerned with how the present situation originated. His only concern is to make the best use of the means available today for the best possible removal of future uneasiness. The past does not count for him. He has at his disposal a definite quantity of material factors of production. He does not ask whether these factors are nature-given or the product of production processes accomplished in the past. It does not matter for him how great a quantity of nature-given, i.e., original material factors of production and labor, was expended in their production and how much time these processes of production have absorbed. He values the available means exclusively from the aspect of the services they can render him in his endeavors to make future conditions more satisfactory. The period of production and the duration of serviceableness are for him categories in planning future action, not concepts of academic retrospection and historical research. They play a role in so far as the actor has to choose between periods of production of different length and between the production of more durable and less durable goods.

Action is not concerned with the future in general, but always Edition: current; Page: [481] with a definite and limited fraction of the future. This fraction is limited, on the one side, by the instant in which the action must take place. Where its other end lies depends on the actor’s decision and choice. There are people who are concerned with only the impending instant. There are other people whose provident care stretches far beyond the prospective length of their own life. We may call the fraction of future time for which the actor in a definite action wants to provide in some way and to some extent, the period of provision. In the same way in which acting man chooses among various kinds of want-satisfaction within the same fraction of future time, he chooses also between want-satisfaction in the nearer and in the remoter future. Every choice implies also a choice of a period of provision. In making up his mind how to employ the various means available for the removal of uneasiness, man also determines implicitly the period of provision. In the market economy the demand of the consumers also determines the length of the period of provision.

There are various methods available for a lengthening of the period of provision:

1. The accumulation of larger stocks of consumers’ goods destined for later consumption.

2. The production of goods which are more durable.

3. The production of goods requiring a longer period of production.

4. The choice of methods of production consuming more time for the production of goods which could also be produced within a shorter period of production.

The first two methods do not require any further comment. The third and the fourth methods must be scrutinized more closely.

It is one of the fundamental data of human life and action that the shortest processes of production, i.e., those with the shortest period of production, do not remove felt uneasiness entirely. If all those goods which these shortest processes can provide are produced, unsatisfied wants remain and incentive to further action is still present. As acting man prefers those processes which, other things being equal, produce the products in the shortest time,1 only such processes are left for further action which consume more time. People embark upon these more time-consuming processes because they value the increment in satisfaction expected more highly than the disadvantage of waiting longer for their fruits. Böhm-Bawerk speaks of the higher productivity of roundabout ways of production requiring more time. It is more appropriate to speak of the higher physical productivity Edition: current; Page: [482] of production processes requiring more time. The higher productivity of these processes does not always consist in the fact that they produce—with the same quantity of factors of production expended—a greater quantity of products. More often it consists in the fact that they produce products which could not be produced at all in shorter periods of production. These processes are not roundabout processes. They are the shortest and quickest way to the goal chosen. If one wants to catch more fish, there is no other method available than the substitution of fishing with the aid of nets and canoes for fishing without the aid of this equipment. There is no better, shorter, and cheaper method for the production of aspirin known than that adopted by the chemical plants. If one disregards error and ignorance, there cannot be any doubt about the highest productivity and expediency of the processes chosen. If people had not considered them the most direct processes, viz., those leading by the shortest way to the end sought, they would not have adopted them.

The lengthening of the period of provision through the mere accumulation of stocks of consumers’ goods is the outcome of the desire to provide in advance for a longer period of time. The same is valid for the production of goods the durability of which is greater in proportion to the greater expenditure of factors of production required.2 But if temporally remoter goals are aimed at, lengthening of the period of production is a necessary corollary of the venture. The end sought cannot be attained in a shorter period of production.

The postponement of an act of consumption means that the individual prefers the satisfaction which later consumption will provide to the satisfaction which immediate consumption could provide. The choice of a longer period of production means that the actor values the product of the process bearing fruit only at a later date more highly than the products which a process consuming less time could provide. In such deliberations and the resulting choices the period of production appears as waiting time. It was the great contribution of Jevons and Böhm-Bawerk to have shown the role played by taking account of waiting time.

If acting men were not to pay heed to the length of the waiting time, they would never say that a goal is temporally so distant that one cannot consider aiming at it. Faced with the alternative of choosing between two processes of production which render different output with the same input, they would always prefer that process which renders the greater quantity of the same products or better products Edition: current; Page: [483] in the same quantity, even if this result could be attained only by lengthening the period of production. Increments in input which result in a more than proportionate increase in the products’ duration of serviceableness would unconditionally be deemed advantageous. The fact that men do not act in this way evidences that they value fractions of time of the same length in a different way according as they are nearer or remoter from the instant of the actor’s decision. Other things being equal, satisfaction in a nearer period of the future is preferred to satisfaction in a more distant period; disutility is seen in waiting.

This fact is already implied in the statement stressed in the opening of this chapter that man distinguishes the time before satisfaction is attained and the time for the duration of which there is satisfaction. If any role at all is played by the time element in human life, there cannot be any question of equal valuation of nearer and remoter periods of the same length. Such an equal valuation would mean that people do not care whether success is attained sooner or later. It would be tantamount to a complete elimination of the time element from the process of valuation.

The mere fact that goods with a longer duration of serviceableness are valued more highly than those with a shorter duration does not yet in itself imply a consideration of time. A roof that can protect a house against the weather during a period of ten years is more valuable than a roof which renders this service only for a period of five years. The quantity of service rendered is different in both cases. But the question which we have to deal with is whether or not an actor in making his choices attaches to a service to be available in a later period of the future the same value he attaches to a service available at an earlier period.

2: Time Preference as an Essential Requisite of Action

The answer to this question is that acting man does not appraise time periods merely with regard to their dimension. His choices regarding the removal of future uneasiness are directed by the categories sooner and later. Time for man is not a homogeneous substance of which only length counts. It is not a more or a less in dimension. It is an irreversible flux the fractions of which appear in different perspective according to whether they are nearer to or remoter from the instant of valuation and decision. Satisfaction of a want in the nearer future is, other things being equal, preferred to that in the farther distant future. Present goods are more valuable than future goods.

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Time preference is a categorial requisite of human action. No mode of action can be thought of in which satisfaction within a nearer period of the future is not—other things being equal—preferred to that in a later period. The very act of gratifying a desire implies that gratification at the present instant is preferred to that at a later instant. He who consumes a nonperishable good instead of postponing consumption for an indefinite later moment thereby reveals a higher valuation of present satisfaction as compared with later satisfaction. If he were not to prefer satisfaction in a nearer period of the future to that in a remoter period, he would never consume and so satisfy wants. He would always accumulate, he would never consume and enjoy. He would not consume today, but he would not consume tomorrow either, as the morrow would confront him with the same alternative.

Not only the first step toward want-satisfaction, but also any further step is guided by time preference. Once the desire a to which the scale of values assigns the rank 1 is satisfied, one must choose between the desire b to which the rank 2 is assigned and c that desire of tomorrow to which—in the absence of time preference—the rank 1 would have been assigned. If b is preferred to c, the choice clearly involves time preference. Purposive striving after want-satisfaction must needs be guided by a preference for satisfaction in the nearer future over that in a remoter future.

The conditions under which modern man of the capitalist West must act are different from those under which his primitive ancestors lived and acted. As a result of the providential care of our forebears we have at our disposal an ample stock of intermediate products (capital goods or produced factors of production) and of consumers’ goods. Our activities are designed for a longer period of provision because we are the lucky heirs of a past which has lengthened, step by step, the period of provision and has bequeathed to us the means to expand the waiting period. In acting we are concerned with longer periods and are aiming at an even satisfaction in all parts of the period chosen as the period of provision. We are in a position to rely upon a continuing influx of consumers’ goods and have at our disposal not only stocks of goods ready for consumption but also stocks of producers’ goods out of which our continuous efforts again and again make new consumers’ goods mature. In our dealing with this increasing “stream of income,” says the superficial observer, there is no heed paid to any considerations related to a different valuation of present and of future goods. We synchronize, he asserts, and thus the time element loses any importance for the conduct of Edition: current; Page: [485] affairs. It is, therefore, pointless, he continues, in the interpretation of modern conditions to resort to time preference.

The fundamental error involved in this popular objection is caused, like so many other errors, by a lamentable misapprehension of the imaginary construction of the evenly rotating economy. In the frame of this imaginary construction no change occurs; there prevails an unvarying course of all affairs. In the evenly rotating economy consequently nothing is altered in the allocation of goods for the satisfaction of wants in nearer and in remoter periods of the future. No one plans any change because—according to our assumptions—the prevailing allocation best serves him and because he does not believe that any possible rearrangement could improve his condition. No one wants to increase his consumption in a nearer period of the future at the expense of his consumption in a more distant period or vice versa because the existing mode of allocation pleases him better than any other thinkable and feasible mode.

The praxeological distinction between capital and income is a category of thought based on a different valuation of want-satisfaction in various periods of the future. In the imaginary construction of the evenly rotating economy it is implied that the whole income but not more than the income is consumed and that therefore the capital remains unchanged. An equilibrium is reached in the allocation of goods for want-satisfaction in different periods of the future. It is permissible to describe this state of affairs by asserting that nobody wants to consume tomorrow’s income today. We have precisely designed the imaginary construction of the evenly rotating economy in such a way as to make it fit just this condition. But it is necessary to realize that we can assert with the same apodictic assurance that, in the evenly rotating economy, nobody wants to have more of any commodity than he really has. These statements are true with regard to the evenly rotating economy because they are implied in our definition of this imaginary construction. They are nonsensical when asserted with regard to a changing economy which is the only real economy. As soon as a change in the data occurs, the individuals are faced anew with the necessity of choosing both between various modes of want-satisfaction in the same period and between want-satisfaction in different periods. An increment can be either employed for immediate consumption or invested for further production. No matter how the actors employ it, their choice must needs be the result of a weighing of the advantages expected from want-satisfaction in different periods of the future. In the world of reality, in the living and changing universe, each individual in each of his actions is forced Edition: current; Page: [486] to choose between satisfaction in various periods of time. Some people consume all that they earn, others consume a part of their capital, others save a part of their income.

Those contesting the universal validity of time preference fail to explain why a man does not always invest a sum of 100 dollars available today, although these 100 dollars would increase to 104 dollars within a year’s time. It is obvious that this man in consuming this sum today is determined by a judgment of value which values 100 present dollars higher than 104 dollars available a year later. But even in case he chooses to invest these 100 dollars, the meaning is not that he prefers satisfaction in a later period to that of today. It means that he values 100 dollars today less than 104 dollars a year later. Every penny spent today is, precisely under the conditions of a capitalist economy in which institutions make it possible to invest even the smallest sums, a proof of the higher valuation of present satisfaction as compared with later satisfaction.

The theorem of time preference must be demonstrated in a double way. First for the case of plain saving in which people must choose between the immediate consumption of a quantity of goods and the later consumption of the same quantity. Second for the case of capitalist saving in which the choice is to be made between the immediate consumption of a quantity of goods and the later consumption either of a greater quantity or of goods which are fit to provide a satisfaction which—except for the difference in time—is valued more highly. The proof has been given for both cases. No other case is thinkable.

It is possible to search for a psychological understanding of the problem of time preference. Impatience and the pains caused by waiting are certainly psychological phenomena. One may approach their elucidation by referring to the temporal limitations of human life, to the individual’s coming into existence, his growth and maturing, and his inevitable decay and passing away. There is in the course of a man’s life a right moment for everything as well as a too early and a too late. However, the praxeological problem is in no way related to psychological issues. We must conceive, not merely understand. We must conceive that a man who does not prefer satisfaction within a nearer period of the future to that in a remoter period would never achieve consumption and enjoyment at all.

Neither must the praxeological problem be confused with the physiological. He who wants to live to see the later day, must first of all care for the preservation of his life in the intermediate period. Survival and appeasement of vital needs are thus requirements for the satisfaction of any wants in the remoter future. This makes us understand Edition: current; Page: [487] why in all those situations in which bare life in the strict sense of the term is at stake satisfaction in the nearer future is preferred to that in later periods. But we are dealing with action as such, not with the motives directing its course. In the same way in which as economists we do not ask why albumin, carbohydrates, and fat are demanded by man, we do not inquire why the satisfaction of vital needs appears imperative and does not brook any delay. We must conceive that consumption and enjoyment of any kind presuppose a preference for present satisfaction to later satisfaction. The knowledge provided by this insight far exceeds the orbit for which the physiological facts concerned provide explanation. It refers to every kind of want-satisfaction, not only to the satisfaction of the vital necessities of mere survival.

It is important to stress this point because the term “supply of subsistence, available for advances of subsistence,” as used by Böhm-Bawerk, can easily be misinterpreted. It is certainly one of the tasks of this stock to provide the means for a satisfaction of the bare necessities of life and thus to secure survival. But besides it must be large enough to satisfy, beyond the requirements of necessary maintenance for the waiting time, all those wants and desires which—apart from mere survival—are considered more urgent than the harvesting of the physically more abundant fruits of production processes consuming more time.

Böhm-Bawerk declared that every lengthening of the period of production depends on the condition that “a sufficient quantity of present goods is available to make it possible to overbridge the lengthened average interval between the starting of preparatory work and the harvesting of its product.”3 The expression “sufficient quantity” needs elucidation. It does not mean a quantity sufficient for necessary sustenance. The quantity in question must be large enough to secure the satisfaction of all those wants the satisfaction of which during the waiting time is considered more urgent than the advantages which a still greater lengthening of the period of production would provide. If the quantity in question were smaller, a shortening of the period of production would appear advantageous; the increase in the quantity of products or the improvement of their quality to be expected from the preservation of the longer period of production would no longer be considered a sufficient remuneration for the restriction of consumption enjoined during the waiting time. Whether or not the supply of subsistence is sufficient, does not depend on any Edition: current; Page: [488] physiological or other facts open to objective determination by the methods of technology and physiology. The metaphorical term “overbridge,” suggesting a body of water the breadth of which poses to the bridge builder an objectively determined task, is misleading. The quantity in question is valued by men, and their subjective judgments decide whether or not it is sufficient.

Even in a hypothetical world in which nature provides every man with the means for the preservation of biological survival (in the strict sense of the term), in which the most important foodstuffs are not scarce and action is not concerned with the provision for bare life, the phenomenon of time preference would be present and direct all actions.4

Observations on the Evolution of the Time-Preference Theory

It seems plausible to assume that the mere fact that interest is graduated in reference to periods of time should have directed the attention of the economists, intent upon developing a theory of interest, upon the role played by time. However, the classical economists were prevented by their faulty theory of value and their misconstruction of the cost concept from recognizing the significance of the time element.

Economics owes the time-preference theory to William Stanley Jevons and its elaboration, most of all, to Eugen von Böhm-Bawerk. Böhm-Bawerk was the first to formulate correctly the problem to be solved, the first to unmask the fallacies implied in the productivity theories of interest, and the first to stress the role played by the period of production. But he did not entirely succeed in avoiding the pitfalls in the elucidation of the interest problem. His demonstration of the universal validity of time preference is inadequate because it is based on psychological considerations. However, psychology can never demonstrate the validity of a praxeological theorem. It may show that some people or many people let themselves be influenced by certain motives. It can never make evident that all human action is necessarily dominated by a definite categorial element which, without any exception, is operative in every instance of action.5

The second shortcoming of Böhm-Bawerk’s reasoning was his misconstruction of the concept of the period of production. He was not fully aware of the fact that the period of production is a praxeological category and that the role it plays in action consists entirely in the choices acting man makes between periods of production of different Edition: current; Page: [489] length. The length of time expended in the past for the production of capital goods available today does not count at all. These capital goods are valued only with regard to their usefulness for future want-satisfaction. The “average period of production” is an empty concept. What determines action is the fact that in choosing among various ways which can remove future uneasiness the length of the waiting time in each case is a necessary element.

It was an outcome of these two errors that Böhm-Bawerk in the elaboration of his theory did not entirely avoid the productivity approach which he himself had so brilliantly refuted in his critical history of the doctrines of capital and interest.

These observations do not detract at all from the imperishable merits of Böhm-Bawerk’s contributions. It was on the foundation laid by him that later economists—foremost among them Knut Wicksell, Frank Albert Fetter and Irving Fisher—were successful in perfecting the time-preference theory.

It is customary to express the essence of the time-preference theory by saying that there prevails a preference for present over future goods. In dealing with this mode of expression some economists have been puzzled by the fact that in some cases present uses are worth less than future uses. However, the problem raised by the apparent exceptions is caused merely by a misapprehension of the true state of affairs.

There are enjoyments which cannot be had at the same time. A man cannot on the same evening attend performances of Carmen and of Hamlet. In buying a ticket he must choose between the two performances. If tickets to both theaters for the same evening are presented to him as a gift, he must likewise choose. He may think with regard to the ticket which he refuses: “I don’t care for it just now,” or “If only it had been later.”6 However, this does not mean that he prefers future goods to present goods. He does not have to choose between future goods and present goods. He must choose between two enjoyments both of which he cannot have together. This is the dilemma in every instance of choosing. In the present state of his affairs he may prefer Hamlet to Carmen. The different conditions of a later date may possibly result in another decision.

The second seeming exception is presented by the case of perishable goods. They may be available in abundance in one season of the year and may be scarce in other seasons. However, the difference between ice in winter and ice in summer is not that between a present good and a future good. It is the difference between a good that loses its specific usefulness even if not consumed and another good which requires a different process of production. Ice available in winter can only be used in summer when subjected to a special process of conservation. It is, in respect to ice utilizable in summer, at best one of Edition: current; Page: [490] the complementary factors required for production. It is impossible to increase the quantity of ice available in summer simply by restricting the consumption of ice in winter. The two things are for all practical purposes different commodities.

The case of the miser does not contradict the universal validity of time preference. The miser too, in spending some of his means for a scanty livelihood, prefers some amount of satisfaction in the nearer future to that in the remoter future. Extreme instances in which the miser denies himself even the indispensable minimum of food represent a pathological withering away of vital energy, as is the case with the man who abstains from eating out of fear of morbific germs, the man who commits suicide rather than meet a dangerous situation, and the man who cannot sleep because he is afraid of undetermined accidents which could befall him while asleep.

3: Capital Goods

As soon as those present wants are sated, the satisfaction of which is considered more urgent than any provision for the morrow, people begin to save a part of the available supply of consumers’ goods for later use. This postponement of consumption makes it possible to direct action toward temporally remoter ends. It is now feasible to aim at goals which could not be thought of before on account of the length of the period of production required. It is furthermore feasible to choose methods of production in which the output of products is greater per unit of input than in other methods requiring a shorter period of production. The sine qua non of any lengthening of the processes of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way.

The postponement of consumption and the accumulation of stocks of consumers’ goods destined for later consumption would be practiced even in the absence of the stimulus offered by the technological superiority of processes with a longer period of production. The higher productivity of such processes consuming more time strengthens considerably the propensity to save. The sacrifice made by restricting consumption in nearer periods of the future is henceforth not only counterbalanced by the expectation of consuming the saved goods in remoter periods; it also opens the way to a more ample supply in the remoter future and to the attainment of goods which could not be procured at all without this provisional sacrifice. If acting man, other conditions being equal, were not to prefer, without exception, consumption in the nearer future to that in the remoter Edition: current; Page: [491] future, he would always save, never consume. What restricts the amount of saving and investment is time preference.

People eager to embark upon processes with a longer period of production must first accumulate, by means of saving, that quantity of consumers’ goods which is needed to satisfy, during the waiting time, all those wants, the satisfaction of which they consider more urgent than the increment in well-being expected from the more time-consuming process. Accumulation of capital begins with the formation of stocks of consumers’ goods, the consumption of which is postponed for later days. If these surpluses are merely stored and kept for later consumption, they are simply wealth or, more precisely, a reserve for rainy days and emergencies. They remain outside the orbit of production. They become integrated—economically, not physically—into production activities only when employed as means of subsistence of workers engaged in more time-consuming processes. If expended in this way, they are physically consumed. But economically they do not disappear. They are replaced first by the intermediary products of a process with a longer period of production and then later by the consumers’ goods which are the final product of these processes.

All these ventures and processes are intellectually controlled by capital accounting, the acme of economic calculation in monetary terms. Without the aid of monetary calculation men could not even learn whether—apart from the length of the period of production—a definite process promises a higher productivity than another. The expenditures required by various processes cannot be weighed against one another without the aid of monetary terms. Capital accounting starts with the market prices of the capital goods available for further production, the sum of which it calls capital. It records every expenditure from this fund and the price of all incoming items induced by such expenditures. It establishes finally the ultimate outcome of all these transformations in the composition of the capital and thereby the success or the failure of the whole process. It shows not only the final result; it mirrors also every one of its intermediary stages. It produces interim balances for every day such a balance may be required and statements of profit and loss for every part or stage of the process. It is the indispensable compass of production in the market economy.

In the market economy production is a continuous, never-ending pursuit split up into an immense variety of partial processes. Innumerable processes of production with different periods of production are in progress simultaneously. They complement one another and at Edition: current; Page: [492] the same time are in rivalry with one another in competing for scarce factors of production. Continuously either new capital is accumulated by saving or previously accumulated capital is eaten up by over-consumption. Production is distributed among numerous individual plants, farms, workshops, and enterprises, each of which serves only limited purposes. The intermediary products or capital goods, the produced factors of further production, change hands in the course of events; they pass from one plant to another until finally the consumers’ goods reach those who use and enjoy them. The social process of production never stops. At each instant numberless processes are in progress, some of which are nearer to, some remoter from, the achievement of their special tasks.

Every single performance in this ceaseless pursuit of wealth production is based upon the saving and the preparatory work of earlier generations. We are the lucky heirs of our fathers and forefathers whose saving has accumulated the capital goods with the aid of which we are working today. We favorite children of the age of electricity still derive advantage from the original saving of the primitive fishermen who, in producing the first nets and canoes, devoted a part of their working time to provision for a remoter future. If the sons of these legendary fishermen had worn out these intermediary products—nets and canoes—without replacing them by new ones, they would have consumed capital and the process of saving and capital accumulation would have had to start afresh. We are better off than earlier generations because we are equipped with the capital goods they have accumulated for us.7

The businessman, the acting man, is entirely absorbed in one task only: to take best advantage of all the means available for the improvement of future conditions. He does not look at the present state of affairs with the aim of analyzing and comprehending it. In classifying the means for further production and appraising their importance he adopts superficial rules of thumb. He distinguishes three classes of factors of production: the nature-given material factors, the human factor—labor, and capital goods—the intermediary factors produced in the past. He does not analyze the nature of the capital goods. They are in his eyes means of increasing the productivity of labor. Quite naïvely he ascribes to them productive power of their own. He does not trace their instrumentality back to nature and labor. He does not ask how they came into existence. They Edition: current; Page: [493] count only as far as they may contribute to the success of his efforts.

This mode of reasoning is all right for the businessman. But it was a serious mistake for the economists to agree with the businessman’s superficial view. They erred in classifying “capital” as an independent factor of production along with the nature-given material resources and labor. The capital goods—the factors of further production produced in the past—are not an independent factor. They are the joint products of the cooperation of the two original factors—nature and labor—expended in the past. They have no productive power of their own.

Neither is it correct to call the capital goods labor and nature stored up. They are rather labor, nature, and time stored up. The difference between production without the aid of capital goods and that assisted by the employment of capital goods consists in time. Capital goods are intermediary stations on the way leading from the very beginning of production to its final goal, the turning out of consumers’ goods. He who produces with the aid of capital goods enjoys one great advantage over the man who starts without capital goods; he is nearer in time to the ultimate goal of his endeavors.

There is no question of an alleged productivity of capital goods. The difference between the price of a capital good, e.g., a machine, and the sum of the prices of the complementary original factors of production required for its reproduction is entirely due to the time difference. He who employs the machine is nearer the goal of production. The period of production is shorter for him than for a competitor who must start from the beginning. In buying a machine he buys the original factors of production that were expended in producing it plus time, i.e., the time by which his period of production is shortened.

The value of time, i.e., time preference or the higher valuation of want-satisfaction in nearer periods of the future as against that in remoter periods, is an essential element in human action. It determines every choice and every action. There is no man for whom the difference between sooner and later does not count. The time element is instrumental in the formation of all prices of all commodities and services.

4: Period of Production, Waiting Time, and Period of Provision

If one were to measure the length of the period of production spent in the fabrication of the various goods available now, one would have to trace back their history to the point at which the first expenditure Edition: current; Page: [494] of original factors of production took place. One would have to establish when natural resources and labor were first employed for processes which—besides contributing to the production of other goods—also contributed ultimately to the production of the good in question. The solution of this problem would require the solubility of the problem of physical imputation. It would be necessary to establish in quantitative terms to what extent tools, raw materials, and labor which directly or indirectly were used in the production of the good concerned contributed to the result. One would have to go back in these inquiries to the very origins of capital accumulation by saving on the part of people who previously lived from hand to mouth. It is not only practical difficulties which prevent such historical studies. The very insolubility of the problem of physical imputation stops us at the first step of such ventures.

Neither acting man himself nor economic theory needs a measurement of the time expended in the past for the production of goods available today. They would have no use for such data even if they knew them. Acting man is faced with the problem of how to take best advantage of the available supply of goods. He makes his choices in employing each part of this supply in such a way as to satisfy the most urgent of the not yet satisfied wants. For the achievement of this task he must know the length of the waiting time which separates him from the attainment of the various goals among which he has to choose. As has been pointed out and must be emphasized again, there is no need for him to look backward to the history of the various capital goods available. Acting man counts waiting time and the period of production always from today on. In the same way in which there is no need to know whether more or less labor and material factors of production have been expended in the production of the products available now, there is no need to know whether their production has absorbed more or less time. Things are valued exclusively from the point of view of the services they can render for the satisfaction of future wants. The actual sacrifices made and the time absorbed in their production are beside the point. These things belong to the dead past.

It is necessary to realize that all economic categories are related to human action and have nothing at all to do directly with the physical properties of things. Economics is not about goods and services; it is about human choice and action. The praxeological concept of time is not the concept of physics or biology. It refers to the sooner or the later as operative in the actors’ judgments of value. The distinction between capital goods and consumers’ goods is not a rigid Edition: current; Page: [495] distinction based on the physical and physiological properties of the goods concerned. It depends on the position of the actors and the choices they have to make. The same goods can be looked upon as capital goods or as consumers’ goods. A supply of goods ready for immediate enjoyment is capital goods from the point of view of a man who looks upon it as a means for his own sustenance and that of hired workers during a waiting time.

An increase in the quantity of capital goods available is a necessary condition for the adoption of processes in which the period of production and therefore waiting time are longer. If one wants to attain ends which are temporally farther away, one must resort to a longer period of production because it is impossible to attain the end sought in a shorter period of production. If one wants to resort to methods of production with which the quantity of output is higher per unit of input expended, one must lengthen the period of production. For the processes with which output is smaller per unit of input have been chosen only on account of the shorter period of production they require. But on the other hand, not every employment chosen for the utilization of capital goods accumulated by means of additional saving requires a process of production in which the period of production from today on to the maturing of the product is longer than with all processes already adopted previously. It may be that people, having satisfied their more urgent needs, now want goods which can be produced within a comparatively short period. The reason why these goods have not been produced previously was not that the period of production they require was deemed too long, but that there was a more urgent employment open for the factors required.

If one chooses to assert that every increase in the supply of capital goods available results in a lengthening of the period of production and of waiting time, one reasons in the following way: If a are the goods already previously produced and b the goods produced in the new processes started with the aid of the increase in capital goods, it is obvious that people had to wait longer for a and b than they had to wait for a alone. In order to produce a and b it was not only necessary to acquire the capital goods required for the production of a, but also those required for the production of b. If one had expended for an increase of immediate consumption the means of sustenance saved to make workers available for the production of b, one would have attained the satisfaction of some wants sooner.

The treatment of the capital problem customary with those economists who are opposed to the so-called “Austrian” view assumes that the technique employed in production is unalterably determined by Edition: current; Page: [496] the given state of technological knowledge. The “Austrian” economists, on the other hand, show that it is the supply of capital goods available at each moment that determines which of the many known technological methods of production will be employed.8 The correctness of the “Austrian” point of view can easily be demonstrated by a scrutiny of the problem of relative scarcity of capital.

Let us look at the condition of a country suffering from such scarcity of capital. Take, for instance, the state of affairs in Rumania about 1860. What was lacking was certainly not technological knowledge. There was no secrecy concerning the technological methods practiced by the advanced nations of the West. They were described in innumerable books and taught at many schools. The elite of Rumanian youth had received full information about them at the technological universities of Austria, Switzerland, and France. Hundreds of foreign experts were ready to apply their knowledge and skill in Rumania. What was wanting were the capital goods needed for a transformation of the backward Rumanian apparatus of production, transportation, and communication according to Western patterns. If the aid granted to the Rumanians on the part of the advanced foreign nations had consisted merely in providing them with technological knowledge, they would have had to realize that it would take a very long time until they caught up with the West. The first thing for them to have done would have been to save in order to make workers and material factors of production available for the performance of more time-consuming processes. Only then could they successively produce the tools required for the construction of those plants which in the further course were to produce the equipment needed for the construction and operation of modern plants, farms, mines, railroads, telegraph lines, and buildings. Scores of decades would have passed until they had made up for the time lost. There would not have been any means of accelerating this process than by restricting current consumption as far as physiologically possible for the intermediary period.

However, things developed in a different way. The capitalist West lent to the backward countries the capital goods needed for an instantaneous transformation of a great part of their methods of production. It saved them time and made it possible for them to Edition: current; Page: [497] multiply very soon the productivity of their labor. The effect for the Rumanians was that they could immediately enjoy the advantages derived from the modern technological procedures. It was as if they had started at a much earlier date to save and to accumulate capital goods.

Shortage of capital means that one is further away from the attainment of a goal sought than if one had started to aim at it at an earlier date. Because one neglected to do this in the past, the intermediary products are wanting, although the nature-given factors from which they are to be produced are available. Capital shortage is dearth of time. It is the effect of the fact that one was late in beginning the march toward the aim concerned. It is impossible to describe the advantages derived from capital goods available and the disadvantages resulting from the paucity of capital goods without resorting to the time element of sooner and later.9

To have capital goods at one’s disposal is tantamount to being nearer to a goal aimed at. An increment in capital goods available makes it possible to attain temporally remoter ends without being forced to restrict consumption. A loss in capital goods, on the other hand, makes it necessary either to abstain from striving after certain goals which one could aim at before or to restrict consumption. To have capital goods means, other things being equal,10 a temporal gain. As against those who lack capital goods, the capitalist, under the given state of technological knowledge, is in a position to reach a definite goal sooner without restricting consumption and without increasing the input of labor and nature-given material factors of production. His head start is in time. A rival endowed with a smaller supply of capital goods can catch up only by restricting his consumption.

The start which the peoples of the West have gained over the other peoples consists in the fact that they have long since created the political and institutional conditions required for a smooth and by and large uninterrupted progress of the process of larger-scale saving, capital accumulation, and investment. Thus, by the middle of the nineteenth century, they had already attained a state of well-being which far surpassed that of races and nations less successful in substituting the ideas of acquisitive capitalism for those of predatory militarism. Left alone and unaided by foreign capital these backward peoples would have needed much more time to improve their methods of production, transportation, and communication.

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It is impossible to understand the course of world affairs and the development of the relations between West and East in the last centuries, if one does not comprehend the importance of this large-scale transfer of capital. The West has given to the East not only technological and therapeutical knowledge, but also the capital goods needed for an immediate practical application of this knowledge. These nations of Eastern Europe, Asia, and Africa have been able, thanks to the foreign capital imported, to reap the fruits of modern industry at an earlier date. They were to some extent relieved from the necessity of restricting their consumption in order to accumulate a sufficient stock of capital goods. This was the true nature of the alleged exploitation of the backward nations on the part of Western capitalism about which their nationalists and the Marxians lament. It was a fecundation of the economically backward nations by the wealth of the more advanced nations.

The benefits derived were mutual. What impelled the capitalists of the West to embark upon foreign investment was the demand on the part of the domestic consumers. Consumers asked for goods which could not be produced at all at home and for a cheapening of goods which could be produced at home only with rising costs. If the consumers of the capitalist West had behaved in a different way or if the institutional obstacles to capital export had proved insurmountable, no capital export would have occurred. There would have been more longitudinal expansion of domestic production instead of lateral expansion abroad.

It is not the task of catallactics but of history to deal with the consequences of the internationalization of the capital market, its working, and its final disintegration brought about by the expropriation policies adopted by the receiving countries. Catallactics has only to scrutinize the effects of a richer or poorer supply of capital goods. We compare the conditions of two isolated market systems A and B. Both are equal in size and population figures, the state of technological knowledge, and in natural resources. They differ from one another only in the supply of capital goods, this supply being larger in A than in B. This enjoins that in A many processes of production are employed with which the output is greater per unit of input than with those employed in B. In B one cannot consider the adoption of these processes on account of the comparative scarcity of capital goods. Their adoption would require a restriction of consumption. In B many manipulations are performed by manual labor which in A are performed by labor-saving machines. In A goods are produced with a longer durability; in B one must abstain from producing them Edition: current; Page: [499] although the lengthening of durability is obtained by a less than proportionate increase in input. In A the productivity of labor and consequently wage rates and the standard of living of the wage earners are higher than in B.11

Prolongation of the Period of Provision Beyond the Expected Duration of the Actor’s Life

The judgments of value which determine the choice between satisfaction in nearer and in remoter periods of the future are expressive of present valuation and not of future valuation. They weigh the significance attached today to satisfaction in the nearer future against the significance attached today to satisfaction in the remoter future.

The uneasiness which acting man wants to remove as far as possible is always present uneasiness, i.e., uneasiness felt in the very moment of action, and it always refers to future conditions. The actor is discontented today with the expected state of affairs in various periods of the future and tries to alter it through purposive conduct.

If action is primarily directed toward the improvement of other people’s conditions and is therefore commonly called altruistic, the uneasiness the actor wants to remove is his own present dissatisfaction with the expected state of other people’s affairs in various periods of the future. In taking care of other people he aims at alleviating his own dissatisfaction.

It is therefore not surprising that acting man often is intent upon prolonging the period of provision beyond the expected duration of his own life.

Some Applications of the Time-Preference Theory

Every part of economics is open to intentional misrepresentation and misinterpretation on the part of people eager to excuse or to justify fallacious doctrines underlying their party programs. To prevent such misuse as far as possible it seems expedient to add some explanatory remarks to the exposition of the time-preference theory.

There are schools of thought which flatly deny that men differ with regard to innate characteristics inherited from their ancestors.12 In the opinion of these authors the only difference between the white men of Western civilization and Eskimos is that the latter are in arrears in their progress toward modern industrial civilization. This merely temporal difference of a few thousand years is insignificant when compared with the many hundreds of thousands of years which were absorbed Edition: current; Page: [500] by man’s evolution from the simian state of his apelike forebears to the conditions of present-day Homo sapiens. It does not support the assumption that racial differences prevail between the various specimens of mankind.

Praxeology and economics are foreign to the issues raised by this controversy. But they must take precautionary measures lest they become implicated by partisan spirit in this clash of antagonistic ideas. If those fanatically rejecting the teachings of modern genetics were not entirely ignorant of economics, they would certainly try to turn the time-preference theory to their advantage. They would refer to the circumstance that the superiority of the Western nations consists merely in their having started earlier in endeavors to save and to accumulate capital goods. They would explain this temporal difference by accidental factors, the better opportunity offered by environment.

Against such possible misinterpretations one must emphasize the fact that the temporal head start gained by the Western nations was conditioned by ideological factors which cannot be reduced simply to the operation of environment. What is called human civilization has up to now been a progress from cooperation by virtue of hegemonic bonds to cooperation by virtue of contractual bonds. But while many races and peoples were arrested at an early stage of this movement, others kept on advancing. The eminence of the Western nations consisted in the fact that they succeeded better in checking the spirit of predatory militarism than the rest of mankind and that they thus brought forth the social institutions required for saving and investment on a broader scale. Even Marx did not contest the fact that private initiative and private ownership of the means of production were indispensable stages in the progress from primitive man’s penury to the more satisfactory conditions of nineteenth-century Western Europe and North America. What the East Indies, China, Japan, and the Mohammedan countries lacked were institutions for safeguarding the individual’s rights. The arbitrary administration of pashas, kadis, rajahs, mandarins, and daimios was not conducive to large-scale accumulation of capital. The legal guarantees effectively protecting the individual against expropriation and confiscation were the foundations upon which the unprecedented economic progress of the West came into flower. These laws were not an outgrowth of chance, historical accidents, and geographical environment. They were the product of reason.

We do not know what course the history of Asia and Africa would have taken if these peoples had been left alone. What happened was that some of these peoples were subject to European rule and others—like China and Japan—were forced by the display of naval power to open their frontiers. The achievements of Western industrialism came to them from abroad. They were ready to take advantage of the foreign capital lent to them and invested in their territories. But they Edition: current; Page: [501] were rather slow in the reception of the ideologies from which modern industrialism had sprung. Their assimilation to Western ways of life is superficial.

We are in the midst of a revolutionary process which will very soon do away with all varieties of colonialism. This revolution is not limited to those countries which were subject to the rule of the British, the French and the Dutch. Even nations which without any infringement of their political sovereignty had profited from foreign capital are intent upon throwing off what they call the yoke of foreign capitalists. They are expropriating the foreigners by various devices—discriminatory taxation, repudiation of debts, undisguised confiscation, foreign exchange restrictions. We are on the eve of the complete disintegration of the international capital market. The economic consequences of this event are obvious; its political repercussions are unpredictable.

In order to appreciate the political consequences of the disintegration of the international capital market it is necessary to remember what effects were brought about by the internationalization of the capital market. Under the conditions of the later nineteenth century it did not matter whether or not a nation was prepared and equipped with the required capital in order to utilize adequately the natural resources of its territory. There was practically free access for everybody to every area’s natural wealth. In searching for the most advantageous opportunities for investment, capitalists and promoters were not stopped by national borderlines. As far as investment for the best possible utilization of the known natural resources was concerned, the greater part of the earth’s surface could be considered as integrated into a uniform world-embracing market system. It is true that this result was attained in some areas, like the British and the Dutch East Indies and Malaya, only by colonial regimes and that autochthonous governments of these territories would probably not have created the institutional setting indispensable for the importation of capital. But Eastern and Southern Europe and the Western Hemisphere had of their own accord joined the community of the international capital market.

The Marxians were intent upon indicting foreign loans and investments for the lust for war, conquest, and colonial expansion. In fact the internationalization of the capital market, together with free trade and the freedom of migration, was instrumental in removing the economic incentives to war and conquest. It no longer mattered for a man where the political boundaries of his country were drawn. The entrepreneur and the investor were not checked by them. Precisely those nations which in the age preceding the first World War were paramount in foreign lending and investment were committed to the ideas of peace-loving “decadent” liberalism. Of the foremost aggressor nations Russia, Italy, and Japan were not capital exporters; they themselves needed foreign capital for the development of their own Edition: current; Page: [502] natural resources. Germany’s imperialist adventures were not supported by its big business and finance.13

The disappearance of the international capital market alters conditions entirely. It abolishes the freedom of access to natural resources. If one of the socialist governments of the economically backward nations lacks the capital needed for the utilization of its natural resources, there will be no means to remedy this situation. If this system had been adopted a hundred years ago, it would have been impossible to exploit the oil fields of Mexico, Venezuela, and Iran, to establish the rubber plantations in Malaya or to develop the banana production of Central America. It is illusory to assume that the advanced nations will acquiesce forever in such a state of affairs. They will resort to the only method which gives them access to badly needed raw materials; they will resort to conquest. War is the alternative to freedom of foreign investment as realized by the international capital market.

The inflow of foreign capital did not harm the receiving nations. It was European capital that accelerated considerably the marvelous economic evolution of the United States and the British Dominions. Thanks to foreign capital the countries of Latin America and Asia are today equipped with facilities for production and transportation which they would have had to forego for a very long time if they had not received this aid. Real wage rates and farm yields are higher today in those areas than they would have been in the absence of foreign capital. The mere fact that almost all nations are vehemently asking today for “foreign aid” explodes the fables of the Marxians and the nationalists.

However, the mere lust for imported capital goods does not resuscitate the international capital market. Investment and lending abroad are only possible if the receiving nations are unconditionally and sincerely committed to the principle of private property and do not plan to expropriate the foreign capitalists at a later date. It was such expropriations that destroyed the international capital market.

Intergovernmental loans are no substitute for the functioning of an international capital market. If they are granted on business terms, they presuppose no less than private loans the full acknowledgment of property rights. If they are granted, as is usually the case, as virtual subsidies without any regard for payment of principal and interest, they impose restrictions upon the debtor nation’s sovereignty. In fact such “loans” are for the most part the price paid for military assistance in coming wars. Such military considerations already played an important role in the years in which the European powers prepared the great wars of our age. The outstanding example was provided by the huge sums which the French capitalists, pressed hard by the Government Edition: current; Page: [503] of the Third Republic, lent to Imperial Russia. The Tsars used the capital borrowed for armaments, not for an improvement of the Russian apparatus of production.

5: The Convertibility of Capital Goods

Capital goods are intermediary steps on the way toward a definite goal. If in the course of the period of production the goal is changed, it is not always possible to use the intermediary products already available for the pursuit of the new goal. Some of the capital goods may become absolutely useless, and all expenditure made in their production appears now as waste. Other capital goods could be utilized for the new project but only after having been subjected to a process of adjustment; it would have been possible to spare the costs required by this alteration if one had from the start aimed at the new goal. A third group of capital goods can be employed for the new process without any alteration; but if it had been known at the time they were produced that they would be used in the new way, it would have been possible to manufacture at smaller cost other goods which could render the same service. Finally there are also capital goods which can be employed for the new project just as well as for the original one.

It would hardly be necessary to mention these obvious facts if it were not essential to refute popular misconceptions. There is no such thing as an abstract or ideal capital that exists apart from concrete capital goods. If we disregard the role cash holding plays in the composition of capital (we will deal with this problem in one of the later sections) we must realize that capital is always embodied in definite capital goods and is affected by everything that happens with regard to them. The value of an amount of capital is a derivative of the value of the capital goods in which it is embodied. The money equivalent of an amount of capital is the sum of the money equivalents of the aggregate of capital goods to which one refers in speaking of capital in the abstract. There is nothing which could be called “free” capital. Capital is always in the form of definite capital goods. These capital goods are better utilizable for some purposes, less utilizable for others, and absolutely useless for still other purposes. Every unit of capital is therefore in some way or other fixed capital, i.e., dedicated to definite processes of production. The businessman’s distinction between fixed capital and circulating capital is a difference of degree, not of kind. Everything that is valid with regard to fixed capital is also valid, although to a smaller degree, with regard to circulating capital. All capital goods have a more or less specific character. Of course, Edition: current; Page: [504] with many of them it is rather unlikely that a change in wants and plans will make them entirely useless.

The more a definite process of production approaches its ultimate end, the closer becomes the tie between its intermediary products and the goal aimed at. Iron is less specific in character than iron tubes, and iron tubes less so than iron machine-parts. The conversion of a process of production becomes as a rule the more difficult, the farther it has been pursued and the nearer it has come to its termination, the turning out of consumers’ goods.

In looking at the process of capital accumulation from its very beginnings one can easily recognize that there cannot be such a thing as free capital. There is only capital embodied in goods of a more specific character and in goods of a less specific character. When the wants or the opinions concerning the methods of want-satisfaction change, the value of the capital goods is altered accordingly. Additional capital goods can come into existence only through making consumption lag behind current production. The additional capital is already in the very moment of its coming into existence embodied in concrete capital goods. These goods had to be produced before they could—as an excess of production overconsumption—become capital goods. The role which the interposition [rendered in earlier editions as “intraposition”] of money plays in the sequence of these events will be dealt with later. Here we need only recognize that even the capitalist whose whole capital consists in money and in claims to money does not own free capital. His funds are tied up with money. They are affected by changes in money’s purchasing power and—as far as they are invested in claims to definite sums of money—also by changes in the debtor’s solvency.

It is expedient to substitute the notion of the convertibility of capital goods for the misleading distinction between fixed and free or circulating capital. The convertibility of capital goods is the opportunity offered to adjust their utilization to a change in the data of production. Convertibility is graduated. It is never perfect, i.e., present with regard to all possible changes in the data. In the case of absolutely specific factors it is entirely absent. As the conversion of capital goods from the employment originally planned to other employments becomes necessary through the emergence of unforeseen changes in the data, it is impossible to speak of convertibility in general without reference to changes in the data which have already occurred or are expected. A radical change in the data could make capital goods previously considered to be easily convertible either not convertible at all or convertible only with difficulty.

It is obvious that in practice the problem of convertibility plays a greater role with goods the serviceability of which consists in rendering Edition: current; Page: [505] a series of services over a period of time than with capital goods the serviceability of which is exhausted by rendering only one service in the process of production. The unused capacity of plants and transportation facilities and the scrapping of equipment which according to the plans underlying its production was designed for longer use are more momentous than the throwing away of fabrics and clothing out of fashion and of physically perishable goods. The problem of convertibility is peculiarly a problem of capital and capital goods only in so far as capital accounting makes it especially visible with regard to capital goods. Essentially it is a phenomenon present also in the case of consumers’ goods which an individual has acquired for his own use and consumption. If the conditions which resulted in their acquisition change, the problem of convertibility becomes actual with them too.

Capitalists and entrepreneurs in their capacity as owners of capital are never perfectly free; they are never on the eve of the first decision and action which will bind them. They are always already engaged in some way or other. Their funds are not outside the social process of production, but invested in definite lines. If they own cash, this is, according to the state of the market, either a sound or an unsound “investment”; but it is always an investment. They have either let slip the right moment for the purchase of concrete factors of production which they must buy sooner or later, or the right moment to buy has not yet come. In the first case their holding of cash is unsound; they have missed an opportunity. In the second case their choice was correct.

Capitalists and entrepreneurs in expending money for the purchase of concrete factors of production value the goods exclusively from the point of view of the anticipated future state of the market. They pay prices adjusted to future conditions as they themselves appraise them today. Errors committed in the past in the production of capital goods available today do not burden the buyer; their incidence falls entirely on the seller. In this sense the entrepreneur who proceeds to buy against money capital goods for future production crosses out the past. His entrepreneurial ventures are not affected by changes which in the past occurred in the valuation and the prices of the factors of production he acquires. In this sense alone one may say that the owner of ready cash owns liquid funds and is free.

6: The Influence of the Past Upon Action

The more the accumulation of capital goods proceeds, the greater becomes the problem of convertibility. The primitive methods of farmers and handicraftsmen of earlier ages could more easily be Edition: current; Page: [506] adjusted to new tasks than modern capitalist methods. But it is precisely modern capitalism that is faced with rapid changes in conditions. Changes in technological knowledge and in the demand of the consumers as they occur daily in our time make obsolete many of the plans directing the course of production and raise the question whether or not one should pursue the path started on.

The spirit of sweeping innovation may get hold of men, may triumph over the inhibitions of sluggishness and indolence, may incite the slothful slaves of routine to a radical rescission of traditional valuations, and may peremptorily urge people to enter upon new paths leading to new goals. Doctrinaires may try to forget that we are in all our endeavors the heirs of our fathers, and that our civilization, the product of a long evolution, cannot be transformed at one stroke. But however strong the propensity for innovation may be, it is kept in bounds by a factor that forces men not to deviate too hastily from the course chosen by their forebears. All material wealth is a residuum of past activities and is embodied in concrete capital goods of limited convertibility. The capital goods accumulated direct the actions of the living into lines which they would not have chosen if their discretion had not been restricted by binding action accomplished in the past. The choice of ends and of the means for the attainment of these ends is influenced by the past. Capital goods are a conservative element. They force us to adjust our actions to conditions brought about by our own conduct in earlier days and by the thinking, choosing and acting of bygone generations.

We may picture to ourselves the image of how things would be if, equipped with our present knowledge of natural resources, geography, technology, and hygienics, we had arranged all processes of production and manufactured all capital goods accordingly. We would have located the centers of production in other places. We would have populated the earth’s surface in a different way. Some areas which are today densely inhabited and full of plants and farms would be less occupied. We would have assembled more people and more shops and farms in other areas. All establishments would be equipped with the most efficient machines and tools. Each of them would be the size required for the most economical utilization of its capacity of production. In the world of our perfect planning there would be no technological backwardness, no unused capacity to produce, and no avoidable shipping of men or of goods. The productivity of human exertion would far surpass that prevailing in our actual, imperfect state.

The writings of the socialists are full of such utopian fancies. Edition: current; Page: [507] Whether they call themselves Marxian or non-Marxian socialists, technocrats, or simply planners, they are all eager to show us how foolishly things are arranged in reality and how happily men could live if they were to invest the reformers with dictatorial powers. It is, they say, only the inadequacy of the capitalist mode of production that prevents mankind from enjoying all the amenities which could be produced under the contemporary state of technological knowledge.

The fundamental error involved in this rationalistic romanticism is the misconception of the character of the capital goods available and of their scarcity. The intermediary products available today were manufactured in the past by our ancestors and by ourselves. The plans which guided their production were an outgrowth of the then prevailing ideas concerning ends and technological procedures. If we consider aiming at different ends and choosing different methods of production, we are faced with an alternative. We must either leave unused a great part of the capital goods available and start afresh producing modern equipment, or we must adjust our production processes as far as possible to the specific character of the capital goods available. The choice rests, as it always does in the market economy, with the consumers. Their conduct in buying or not buying settles the issue. In choosing between old tenements and new ones equipped with all the gadgets of comfort, between railroad and motorcar, between gas and electric light, between cotton and rayon goods, between silk and nylon hosiery, they implicitly choose between a continued employment of previously accumulated capital goods and their scrapping. When an old building which could still be inhabited for years is not prematurely demolished and replaced by a modern house because the tenants are not prepared to pay higher rents and prefer to satisfy other wants instead of living in more comfortable homes, it is obvious how present consumption is influenced by conditions of the past.

The fact that not every technological improvement is instantly applied in the whole field is not more conspicuous than the fact that not everybody throws away his old car or his old clothes as soon as a better car is on the market or new patterns become fashionable. In all such things people are motivated by the scarcity of goods available.

A new machine, more efficient than those used previously, is constructed. Whether or not the plants equipped with the old, less efficient machines will discard them in spite of the fact that they are still utilizable and replace them by the new model depends on the degree of the new machine’s superiority. Only if this superiority Edition: current; Page: [508] is great enough to compensate for the additional expenditure required, is the scrapping of the old equipment economically sound. Let p be the price of the new machine, q the price that can be realized by selling the old machine as scrap iron, a the cost of producing one unit of product by the old machine, b the cost of producing one unit of product by the new machine without taking into account the costs required for its purchase. Let us further assume that the eminence of the new machine consists merely in a better utilization of raw material and labor employed and not in manufacturing a greater quantity of products and that thus the annual output z remains unchanged. Then the replacement of the old machine by the new one is advantageous if the yield z(a − b) is large enough to make good for the expenditure of p − q. We may disregard the writing off of depreciation in assuming that the annual quotas are not greater for the new machine than for the old one. The same considerations hold true also for the transfer of an already existing plant from a place in which conditions of production are less favorable to a location offering more favorable conditions.

Technological backwardness and economic inferiority are two different things and must not be confused. It can happen that a production aggregate which from a merely technological point of view appears outclassed is in a position to compete successfully with aggregates better equipped or located at more favorable sites. The degree of the superiority provided by the technologically more efficient equipment or by the more propitious location as compared with the surplus expenditure required for the transformation decides the issue. This relation depends on the convertibility of the capital goods concerned.

The distinction between technological perfection and economic expediency is not, as romantic engineers would have us believe, a feature of capitalism. It is true that only economic calculation as possible solely in a market economy gives the opportunity to establish all the computations required for the cognition of the relevant facts. A socialist management would not be in a position to ascertain the state of affairs by arithmetical methods. It would therefore not know whether or not what it plans and puts into operation is the most appropriate procedure to employ the means available for the satisfaction of what it considers to be the most urgent of the still unsatisfied wants of the people. But if it were in a position to calculate, it would not proceed in a way different from that of the calculating businessman. It would not squander scarce factors of production for the satisfaction of wants deemed less urgent if this would prevent the Edition: current; Page: [509] satisfaction of more urgent wants. It would not hurry to scrap still utilizable production facilities if the investment required would impair the expansion of the production of more urgently needed goods.

If one takes the problem of convertibility into proper account, one can easily explode many widespread fallacies. Take, for instance, the infant industries argument advanced in favor of protection. Its supporters assert that temporary protection is needed in order to develop processing industries in places in which natural conditions for their operation are more favorable or, at least, no less favorable than in the areas in which the already established competitors are located. These older industries have acquired an advantage by their early start. They are now fostered by a merely historical, accidental, and manifestly “irrational” factor. This advantage prevents the establishment of competing plants in areas the conditions of which give promise of becoming able to produce more cheaply than, or at least as cheaply as, the old ones. It may be admitted that protection for infant industries is temporarily expensive. But the sacrifices made will be more than repaid by the gains to be reaped later.

The truth is that the establishment of an infant industry is advantageous from the economic point of view only if the superiority of the new location is so momentous that it outweighs the disadvantages resulting from the abandonment of nonconvertible and nontransferable capital goods invested in the already established plants. If this is the case, the new plants will be able to compete successfully with the old ones without any aid given by the government. If it is not the case, the protection granted to them is wasteful, even if it is only temporary and enables the new industry to hold its own at a later period. The tariff amounts virtually to a subsidy which the consumers are forced to pay as a compensation for the employment of scarce factors of production for the replacement of still utilizable capital goods to be scrapped and the withholding of these scarce factors from other employments in which they could render services valued higher by the consumers. The consumers are deprived of the opportunity to satisfy certain wants because the capital goods required are directed toward the production of goods which were already available to them in the absence of tariffs.

There prevails a universal tendency for all industries to move to those locations in which the potentialities for production are most propitious. In the unhampered market economy this tendency is slowed down as much as due consideration to the inconvertibility of scarce capital goods requires. This historical element does not give a permanent superiority to the old industries. It only prevents Edition: current; Page: [510] the waste originating from investments which bring about unused capacity of still utilizable production facilities on the one hand and a restriction of capital goods available for the satisfaction of unsatisfied wants on the other hand. In the absence of tariffs the migration of industries is postponed until the capital goods invested in the old plants are worn out or become obsolete by technological improvements which are so momentous as to necessitate their replacement by new equipment. The industrial history of the United States provides numerous examples of the shifting, within the boundaries of the country, of centers of industrial production which was not fostered by any protective measures on the part of the authorities. The infant industries argument is no less spurious than all the other arguments advanced in favor of protection.

Another popular fallacy refers to the alleged suppression of useful patents. A patent is a legal monopoly granted for a limited number of years to the inventor of a new contrivance. At this point we are not concerned with the question whether or not it is a good policy to grant such exclusive privileges to inventors.14 We have to deal only with the assertion that “big business” misuses the patent system to withhold from the public benefits it could derive from technological improvement.

In granting a patent to an inventor the authorities do not investigate the invention’s economic significance. They are concerned merely with the priority of the idea and limit their examination to technological problems. They deal with the same impartial scrupulousness with an invention which revolutionizes a whole industry and with some trifling gadget, the uselessness of which is obvious. Thus patent protection is provided to a vast number of quite worthless inventions. Their authors are ready to overrate the importance of their contribution to the progress of technological knowledge and build exaggerated hopes upon the material gain it could bring them. Disappointed, they grumble about the absurdity of an economic system that deprives the people of the benefit of technological progress.

The conditions under which it is economical to substitute new improved equipment for still utilizable older tools have been pointed out above. If these conditions are absent, it does not pay, either for private enterprise in a market economy or for the socialist management of a totalitarian system, to adopt the new technological process immediately. The new machinery to be produced for new plants, the expansion of already existing plants and the replacement of old Edition: current; Page: [511] equipment torn out will be effected according to the new design. But the still utilizable equipment will not be scrapped. The new process will be adopted only step by step. The plants equipped with the old devices are for some time still in a position to stand the competition of those equipped with the new ones. Those questioning the correctness of this statement should ask themselves whether they always throw away their vacuum cleaners or radio sets as soon as better models are offered for sale.

It does not make any difference in this regard whether the new invention is or is not protected by a patent. A firm that has acquired a license has already expended money for the new invention. If it nonetheless does not adopt the new method, the reason is that its adoption does not pay. It is of no avail that the government-created monopoly which the patent provides prevents competitors from applying it. What counts alone is the degree of superiority secured by the new invention as against old methods. Superiority means reduction in the cost of production per unit or such an improvement in the quality of the product that buyers are ready to pay adequately higher prices. The absence of a sufficient degree of superiority to make the cost of transformation profitable is proof of the fact that consumers are more intent upon acquiring other goods than upon enjoying the benefits of the new invention. It is the consumers with whom the ultimate decision rests.

Superficial observers sometimes fail to see these facts because they are deluded by the practice of many big enterprises of acquiring the rights granted by a patent in their field regardless of its usefulness. This practice stems from various considerations:

1. The economic significance of the innovation is not yet recognizable.

2. The innovation is obviously useless. But the firm believes that it could develop it in such a way as to make it useful.

3. The immediate application of the innovation does not pay. But the firm intends to apply it later when replacing its worn-out equipment.

4. The firm wants to encourage the inventor to continue his research in spite of the fact that up to now his endeavors have not resulted in a practically utilizable innovation.

5. The firm wants to placate litigious inventors in order to spare the money, time, and nervous strain which frivolous infringement suits bring about.

6. The firm resorts to hardly disguised bribery or yields to veiled blackmail when paying for quite useless patents to officers, engineers, Edition: current; Page: [512] or other influential personnel of firms or institutions which are its customers or potential customers.

If an invention is so superior to the old processes that it makes the old equipment obsolete and peremptorily demands its immediate replacement by new machines, the transformation will be effected no matter whether the privilege conferred by the patent is in the hands of the owners of the old equipment or of an independent firm. The assertions to the contrary are based on the assumption that not only the inventor and his attorneys but also all people already active in the field of production concerned or prepared to enter into it if an opportunity is offered to them fail entirely to grasp the importance of the invention. The inventor sells his rights to the old firm for a trifle because no one else wants to acquire them. And this old firm is also too dull to see the advantage that it could derive from the application of the invention.

Now, it is true that a technological improvement cannot be adopted if people are blind to its usefulness. Under a socialist management the incompetence or stubbornness of the officers in charge of the department concerned would be enough to prevent the adoption of a more economical method of production. The same is the case with regard to inventions in fields dominated by the government. The most conspicuous examples are provided by the failure of eminent military experts to comprehend the significance of new devices. The great Napoleon did not recognize the help which steamboats could give to his plans to invade Great Britain; both Foch and the German general staff underestimated on the eve of the first World War the importance of aviation, and later the eminent pioneer of air power, General Billy Mitchell, had very unpleasant experiences. But things are entirely different in the orbit in which the market economy is not hampered by bureaucratic narrow-mindedness. There, a tendency to overrate rather than to underestimate the potentialities of an innovation prevails. The history of modern capitalism shows innumerable instances of abortive attempts to push innovations which proved futile. Many promoters have paid heavily for unfounded optimism. It would be more realistic to blame capitalism for its propensity to overvalue useless innovations than for its alleged suppression of useful innovations. It is a fact that large sums have been wasted for the purchase of quite useless patent rights and for fruitless ventures to apply them in practice.

It is absurd to speak of an alleged bias of modern big business against technological improvement. The great corporations spend huge sums in the search for new processes and new devices.

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Those lamenting an alleged suppression of inventions on the part of free enterprise must not think that they have proved their case by referring to the fact that many patents are either never utilized at all or only used after a long delay. It is manifest that numerous patents, perhaps the far greater number of them, are quite useless. Those alleging suppression of useful innovations do not cite a single instance of such an innovation’s being unused in the countries protecting it by a patent while it is used by the Soviets—no respecters of patent privileges.

The limited convertibility of capital goods plays an important role in human geography. The present distribution of human abodes and industrial centers over the earth’s surface is to a certain degree determined by historical factors. The fact that definite sites were chosen in a distant past is still operative. There prevails, it is true, a universal tendency for people to move to those areas which offer the most propitious potentialities for production. However, this tendency is restrained not only by institutional factors, such as migration barriers. A historical factor also plays a momentous role. Capital goods of limited convertibility have been invested in areas which, from the point of view of our present knowledge, offer less favorable opportunities. Their immobilization counteracts the tendency to locate plants, farms, and dwelling places according to the state of our contemporary information about geography, geology, plant and animal physiology, climatology, and other branches of science. Against the advantages of moving toward sites offering better physical opportunities one must weigh the disadvantages of leaving unused capital goods of limited convertibility and transferability.

Thus the degree of convertibility of the supply of capital goods available affects all decisions concerning production and consumption. The smaller the degree of convertibility, the more realization of technological improvement is delayed. Yet it would be absurd to refer to this retarding effect as irrational and antiprogressive. To consider, in planning action, all the advantages and disadvantages expected and to weigh them against one another is a manifestation of rationality. Not the soberly calculating businessman, but the romantic technocrat is to blame for a delusive incomprehension of reality. What slows down technological improvement is not the imperfect convertibility of capital goods, but their scarcity. We are not rich enough to renounce the services which still utilizable capital goods could provide. The fact that a supply of capital goods is available does not check progress; it is, on the contrary, the indispensable condition of any improvement and progress. The heritage of the past Edition: current; Page: [514] embodied in our supply of capital goods is our wealth and the foremost means of further advancement in well-being. It is true we would be still better off if our ancestors and we ourselves in our past actions had succeeded in better anticipating the conditions under which we must act today. The cognizance of this fact explains many phenomena of our time. But it does not cast any blame upon the past nor does it show any imperfection inherent in the market economy.

7: Accumulation, Maintenance and Consumption of Capital

Capital goods are intermediary products which in the further course of production activities are transformed into consumers’ goods. All capital goods, including those not called perishable, perish either in wearing out their serviceableness in the performance of production processes or in losing their serviceableness, even before this happens, through a change in the market data. There is no question of keeping a stock of capital goods intact. They are transient.

The notion of wealth constancy is an outgrowth of deliberate planning and acting. It refers to the concept of capital as applied in capital accounting, not to the capital goods as such. The idea of capital has no counterpart in the physical universe of tangible things. It is nowhere but in the minds of planning men. It is an element in economic calculation. Capital accounting serves one purpose only. It is designed to make us know how our arrangement of production and consumption acts upon our power to satisfy future wants. The question it answers is whether a certain course of conduct increases or decreases the productivity of our future exertion.

The intention of preserving the available supply of capital goods in full power or of increasing it could also direct the actions of men who did not have the mental tool of economic calculation. Primitive fishermen and hunters were certainly aware of the difference between maintaining their tools and devices in good shape and serviceableness and wearing them out without providing for adequate replacements. An old-fashioned peasant, committed to traditional routine and ignorant of accountancy, knows very well the significance of maintaining intact his live and dead stock. Under the simple conditions of a stationary or slowly progressing economy it is feasible to operate successfully even in the absence of capital accounting. There the maintenance of a by and large unchanged supply of capital goods can be effected either by current production of pieces destined to replace those worn out or by the accumulation of a fund of consumers’ Edition: current; Page: [515] goods which makes it possible to devote effort at a later time toward the replacement of such capital goods without being forced to restrict consumption temporarily. But a changing industrial economy cannot do without economic calculation and its fundamental concepts of capital and income.

Conceptual realism has muddled the comprehension of the concept of capital. It has brought about a mythology of capital.15 An existence has been attributed to “capital,” independent of the capital goods in which it is embodied. Capital, it is said, reproduces itself and thus provides for its own maintenance. Capital, says the Marxian, hatches out profit. All this is nonsense.

Capital is a praxeological concept. It is a product of reasoning, and its place is in the human mind. It is a mode of looking at the problems of acting, a method of appraising them from the point of view of a definite plan. It determines the course of human action and is, in this sense only, a real factor. It is inescapably linked with capitalism, the market economy.

The capital concept is operative as far as men in their actions let themselves be guided by capital accounting. If the entrepreneur has employed factors of production in such a way that the money equivalent of the products at least equals the money equivalent of the factors expended, he is in a position to replace the capital goods expended by new capital goods the money equivalent of which equals the money equivalent of those expended. But the employment of the gross proceeds, their allotment to the maintenance of capital, consumption, and the accumulation of new capital is always the outcome of purposive action on the part of the entrepreneurs and capitalists. It is not “automatic”; it is by necessity the result of deliberate action. And it can be frustrated if the computation on which it is based was vitiated by negligence, error, or misjudgment of future conditions.

Additional capital can be accumulated only by saving, i.e., a surplus of production over consumption. Saving may consist in a restriction of consumption. But it can also be brought about, without a further restriction in consumption and without a change in the input of capital goods, by an increase in net production. Such an increase can appear in different ways:

1. Natural conditions have become more propitious. Harvests are more plentiful. People have access to more fertile soil and have discovered mines yielding higher returns per unit of input. Cataclysms and catastrophes which in repeated occurrence frustrated human Edition: current; Page: [516] effort have become less frequent. Epidemics and cattle plagues have subsided.

2. People have succeeded in rendering some production processes more fruitful without investing more capital goods and without a further lengthening of the period of production.

3. Institutional disturbances of production activities have become less frequent. The losses caused by war, revolutions, strikes, sabotage, and other crimes have been reduced.

If the surpluses thus brought about are employed as additional investment, they further increase future net proceeds. Then it becomes possible to expand consumption without prejudice to the supply of capital goods available and the productivity of labor.

Capital is always accumulated by individuals or groups of individuals acting in concert, never by the Volkswirtschaft or the society.16 It may happen that while some actors are accumulating additional capital, others are at the same time consuming capital previously accumulated. If these two processes are equal in amount, the sum of the capital funds available in the market system remains unaltered and it is as if no change in the total amount of capital goods available had occurred. The accumulation of additional capital on the part of some people merely removes the necessity of shortening the period of production of some processes. But no further adoption of processes with a longer period of production becomes feasible. If we look at affairs from this angle we may say that a transfer of capital took place. But one must guard oneself against confusing this notion of capital transfer with the conveyance of property from one individual or group of individuals to others.

The sale and purchase of capital goods and the loans granted to business are not as such capital transfer. They are transactions which are instrumental in conveying the concrete capital goods into the hands of those entrepreneurs who want to employ them for the performance of definite projects. They are only ancillary steps in the course of a long-range sequence of acts. Their composite effect decides the success or failure of the whole project. But neither profit nor loss directly brings about either capital accumulation or capital consumption. It is the way in which those in whose fortune profit or loss occurs arrange their consumption that alters the amount of capital available.

Capital transfer can be effected both without and with a conveyance in the ownership of capital goods. The former is the case when Edition: current; Page: [517] one man consumes capital while another man independently accumulates capital in the same amount. The latter is the case if the seller of capital goods consumes the proceeds while the buyer pays the price out of a nonconsumed—saved—surplus of net proceeds over consumption.

Capital consumption and the physical extinction of capital goods are two different things. All capital goods sooner or later enter into final products and cease to exist through use, consumption, wear and tear. What can be preserved by an appropriate arrangement of consumption is only the value of a capital fund, never the concrete capital goods. It may sometimes happen that acts of God or man-made destruction result in so great an extinction of capital goods that no possible restriction of consumption can bring about in a short time a replenishment of the capital funds to its previous level. But what brings about such a depletion is always the fact that the net proceeds of current production devoted to the maintenance of capital are not sufficiently large.

8: The Mobility of the Investor

The limited convertibility of the capital goods does not immovably bind their owner. The investor is free to alter the investment of his funds. If he is able to anticipate the future state of the market more correctly than other people, he can succeed in choosing only investments whose price will rise and in avoiding investments whose price will drop.

Entrepreneurial profit and loss emanate from the dedication of factors of production to definite projects. Stock exchange speculation and analogous transactions outside the securities market determine on whom the incidence of these profits and losses shall fall. A tendency prevails to make a sharp distinction between such purely speculative ventures and genuinely sound investment. The distinction is one of degree only. There is no such thing as a nonspeculative investment. In a changing economy action always involves speculation. Investments may be good or bad, but they are always speculative. A radical change in conditions may render bad even investments commonly considered perfectly safe.

Stock speculation cannot undo past action and cannot change anything with regard to the limited convertibility of capital goods already in existence. What it can do is to prevent additional investment in branches and enterprises in which, according to the opinion of the speculators, it would be misplaced. It points the specific way for a tendency, prevailing in the market economy, to expand profitable Edition: current; Page: [518] production ventures and to restrict the unprofitable. In this sense the stock exchange becomes simply “the market,” the focal point of the market economy, the ultimate device to make the anticipated demand of the consumers supreme in the conduct of business.

The mobility of the investor manifests itself in the phenomenon misleadingly called capital flight. Individual investors can go away from investments which they consider unsafe provided that they are ready to take the loss already discounted by the market. Thus they can protect themselves against anticipated further losses and shift them to people who are less realistic in their appraisal of the future prices of the goods concerned. Capital flight does not withdraw inconvertible capital goods from the lines of their investment. It consists merely in a change of ownership.

It makes no difference in this regard whether the capitalist “flees” into another domestic investment or into a foreign investment. One of the main objectives of foreign exchange control is to prevent capital flight into foreign countries. However, foreign exchange control only succeeds in preventing the owners of domestic investments from restricting their losses by exchanging in time a domestic investment they consider unsafe for a foreign investment they consider safe.

If all or certain classes of domestic investment are threatened by partial or total expropriation, the market discounts the unfavorable consequences of this policy by an adequate change in their prices. When this happens, it is too late to resort to flight in order to avoid being victimized. Only those investors can come off with a small loss who are keen enough to forecast the disaster at a time when the majority is still unaware of its approach and its significance. Whatever the various capitalists and entrepreneurs may do, they can never make inconvertible capital goods mobile and transferable. While this, at least, is admitted by and large with regard to fixed capital, it is denied with regard to circulating capital. It is asserted that a businessman can export products and fail to reimport the proceeds. People do not see that an enterprise cannot continue its operations when deprived of its circulating capital. If a businessman exports his own funds employed for the current purchase of raw materials, labor, and other essential requirements, he must replace them by funds borrowed. The grain of truth in the fable of the mobility of circulating capital is the fact that it is possible for an investor to avoid losses menacing his circulating capital independently of the avoidance of such losses menacing his fixed capital. However, the process of capital flight is in both instances the same. It is a change in the person Edition: current; Page: [519] of the investor. The investment itself is not affected; the capital concerned does not emigrate.

Capital flight into a foreign country presupposes the propensity of foreigners to exchange their investments abroad against those in the country from which capital flees. A British capitalist cannot flee from his British investments if no foreigner buys them. It follows that capital flight can never result in the much talked about deterioration of the balance of payments. Neither can it make foreign exchange rates rise. If many capitalists—whether British or foreign—want to get rid of British securities, a drop in their prices will ensue. But it will not affect the exchange ratio between the sterling and foreign currencies.

The same is valid with regard to capital invested in ready cash. The owner of French francs who anticipates the consequences of the French government’s inflationary policy can either flee into “real goods” by the purchase of goods or into foreign exchange. But he must find people who are ready to take francs in exchange. He can flee only as long as there are still people left who appraise the future of the franc more optimistically than he himself does. What makes commodity prices and foreign exchange rates rise is not the conduct of those ready to give away francs, but the conduct of those refusing to take them except at a low rate of exchange.

Governments pretend that in resorting to foreign exchange restrictions to prevent capital flight they are motivated by consideration of the nation’s vital interests. What they really bring about is contrary to the material interests of many citizens without any benefit to any citizen or to the phantom of the Volkswirtschaft. If there is inflation going on in France, it is certainly not to the advantage either of the nation as a whole or of any citizen that all the disastrous consequences should affect Frenchmen only. If some Frenchmen were to unload the burden of these losses on foreigners by selling them French banknotes or bonds redeemable in such banknotes, a part of these losses would fall upon foreigners. The manifest outcome of the prevention of such transactions is to make some Frenchmen poorer without making any Frenchmen richer. From the nationalist point of view this hardly seems desirable.

Popular opinion finds something objectionable in every possible aspect of stock market transactions. If prices are rising, the speculators are denounced as profiteers who appropriate to themselves what by rights belongs to other people. If prices drop, the speculators are denounced for squandering the nation’s wealth. The profits of the speculators are vilified as robbery and theft at the expense of the Edition: current; Page: [520] rest of the nation. It is insinuated that they are the cause of the public’s poverty. It is customary to draw a distinction between this dishonest bounty of the jobbers and the profits of the manufacturer who does not merely gamble but supplies the consumers. Even financial writers fail to realize that stock exchange transactions produce neither profits nor losses, but are only the consummation of profits and losses arising in trading and manufacturing. These profits and losses, the outgrowth of the buying public’s approval or disapproval of the investments effected in the past, are made visible by the stock market. The turnover on the stock market does not affect the public. It is, on the contrary, the public’s reaction to the mode in which investors arranged production activities that determines the price structure of the securities market. It is ultimately the consumers’ attitude that makes some stocks rise, others drop. Those not saving and investing neither profit nor lose on account of fluctuations in stock exchange quotations. The trade on the securities market merely decides which investors shall earn profits and which shall suffer losses.17

9: Money and Capital; Saving and Investment

Capital is computed in terms of money and represents in such accounting a definite sum of money. But capital can also consist of amounts of money. As capital goods also are exchanged and as such exchanges are effected under the same conditions as the exchange of all other goods, here too indirect exchange and the use of money become peremptory. In the market economy no participant can forego the advantages which cash holding conveys. Not only in their capacity as consumers, but also in their capacity as capitalists and entrepreneurs, individuals are under the necessity of keeping cash holdings.

Those who have seen in this fact something puzzling and contradictory have been misled by a misconstruction of monetary calculation and capital accounting. They attempt to assign to capital accounting tasks which it can never achieve. Capital accounting is a mental tool of calculating and computing suitable for individuals and groups of individuals acting in the market economy. Only in the frame of monetary calculation can capital become computable. The sole task that capital accounting can perform is to show to the various individuals acting within a market economy whether the money equivalent of their funds devoted to acquisitive action has changed and to Edition: current; Page: [521] what extent. For all other purposes capital accounting is quite useless.

If one tries to ascertain a magnitude called the volkswirtschaftliche capital or the social capital as distinct both from the acquisitive capital of various individuals and from the meaningless concept of the sum of the various individuals’ acquisitive capital funds, then, of course, one is troubled by a spurious problem. What is the role of money, one asks, in such a concept of social capital? One discovers a momentous difference between capital as seen from the individual’s point of view and as seen from the standpoint of society. However, this whole reasoning is utterly fallacious. It is obviously contradictory to eliminate reference to money from the computation of a magnitude which cannot be computed otherwise than in terms of money. It is nonsensical to resort to monetary calculation in an attempt to ascertain a magnitude which is meaningless in an economic system in which there cannot be any money and no money prices for factors of production. As soon as our reasoning passes beyond the frame of a market society, it must renounce every reference to money and money prices. The concept of social capital can only be thought of as a collection of various goods. It is impossible to compare two collections of this type otherwise than by declaring that one of them is more serviceable in removing the uneasiness felt by the whole of society than the other. (Whether or not such a comprehensive judgment can be pronounced by any mortal man is another question.) No monetary expression can be applied to such collections. Monetary terms are void of any meaning in dealing with the capital problems of a social system in which there is no market for factors of production.

In recent years economists have paid special attention to the role cash holding plays in the process of saving and capital accumulation. Many fallacious conclusions have been advanced about this role.

If an individual employs a sum of money not for consumption but for the purchase of factors of production, saving is directly turned into capital accumulation. If the individual saver employs his additional savings for increasing his cash holding because this is in his eyes the most advantageous mode of using them, he brings about a tendency toward a fall in commodity prices and a rise in the monetary unit’s purchasing power. If we assume that the supply of money in the market system does not change, this conduct on the part of the saver will not directly influence the accumulation of capital and its employment for an expansion of production.18 The effect of our Edition: current; Page: [522] saver’s saving, i.e., the surplus of goods produced over goods consumed, does not disappear on account of his hoarding. The prices of capital goods do not rise to the height they would have attained in the absence of such hoarding. But the fact that more capital goods are available is not affected by the striving of a number of people to increase their cash holdings. If nobody employs the goods—the nonconsumption of which brought about the additional saving—for an expansion of his consumptive spending, they remain as an increment in the amount of capital goods available, whatever their prices may be. The two processes—increased cash holding of some people and increased capital accumulation—take place side by side.

A drop in commodity prices, other things being equal, causes a drop in the money equivalent of the various individuals’ capital. But this is not tantamount to a reduction in the supply of capital goods and does not require an adjustment of production activities to an alleged impoverishment. It merely alters the money items to be applied in monetary calculation.

Now let us assume that an increase in the quantity of credit money or of fiat money or credit expansion produces the additional money required for an expansion of the individuals’ cash holdings. Then three processes take their course independently: a tendency toward a fall in commodity prices brought about by the increase in the amount of capital goods available and the resulting expansion of production activities, a tendency toward a fall in prices brought about by an increased demand of money for cash holding, and finally a tendency toward a rise in prices brought about by the increase in the supply of money (in the broader sense). The three processes are to some extent synchronous. Each of them brings about its particular effects which, according to the circumstances, may be intensified or weakened by the opposite effects originating from one of the other two. But the main thing is that the capital goods resulting from the additional saving are not destroyed by the coincident monetary changes—changes in the demand for and the supply of money (in the broader sense). Whenever an individual devotes a sum of money to saving instead of spending it for consumption, the process of saving agrees perfectly with the process of capital accumulation and investment. It does not matter whether the individual saver does or does not increase his cash holding. The act of saving always has its counterpart in a supply of goods produced and not consumed, of goods available for further production activities. A man’s savings are always embodied in concrete capital goods.

The idea that hoarded money is a barren part of the total amount Edition: current; Page: [523] of wealth and that its increase causes shrinkage in that part of wealth that is devoted to production is correct only to the extent that the rise in the monetary unit’s purchasing power results in the employment of additional factors of production for the mining of gold and in the transfer of gold from industrial to monetary employment. But this is brought about by the striving after increased cash holdings and not by saving. Saving, in the market economy, is possible only through abstention from the consumption of a part of income. The individual saver’s employment of his savings for hoarding influences the determination of money’s purchasing power, and may thus reduce the nominal amount of capital, i.e., its money equivalent; it does not render any part of the accumulated capital sterile.

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CHAPTER 19: Interest

1: The Phenomenon of Interest

It has been shown that time preference is a category inherent in every human action. Time preference manifests itself in the phenomenon of originary interest, i.e., the discount of future goods as against present goods.

Interest is not merely interest on capital. Interest is not the specific income derived from the utilization of capital goods. The correspondence between three factors of production—labor, capital, and land—and three classes of income—wages, profit, and rent—as taught by the classical economists is untenable. Rent is not the specific revenue from land. Rent is a general catallactic phenomenon; it plays in the yield of labor and capital goods the same role it plays in the yield of land. Furthermore there is no homogeneous source of income that could be called profit in the sense in which the classical economists applied this term. Profit (in the sense of entrepreneurial profit) and interest are no more characteristic of capital than they are of land.

The prices of consumers’ goods are by the interplay of the forces operating on the market apportioned to the various complementary factors cooperating in their production. As the consumers’ goods are present goods, while the factors of production are means for the production of future goods, and as present goods are valued higher than future goods of the same kind and quantity, the sum thus apportioned, even in the imaginary construction of the evenly rotating economy, falls behind the present price of the consumers’ goods concerned. This difference is the originary interest. It is not specifically connected with any of the three classes of factors of production which the classical economists distinguished. Entrepreneurial profit and loss are produced by changes in the data and the resulting price changes which occur in the passing of the period of production.

Naïve reasoning does not see any problem in the current revenue derived from hunting, fishing, cattle breeding, forestry, and agriculture. Nature generates deer, fish, and cattle and makes them grow, causes the cows to give milk and the chickens to lay eggs, the trees to put on wood and to bear fruit, and the seeds to shoot into ears. Edition: current; Page: [525] He who has a title to appropriate for himself this recurring wealth enjoys a steady income. Like a stream which continually carries new water, the “stream of income” flows continually and conveys again and again new wealth. The whole process appears as a natural phenomenon. But for the economist a problem is presented in the determination of prices for land, cattle, and all the rest. If future goods were not bought and sold at a discount as against present goods, the buyer of land would have to pay a price which equals the sum of all future net revenues and which would leave nothing for a current reiterated income.

The yearly recurring proceeds of the owners of land and cattle are not marked by any characteristic which would catallactically distinguish them from the proceeds stemming from produced factors of production which are used up sooner or later in the processes of production. The power of disposal over a piece of land is the control of this field’s cooperation in the production of all the fruit which can ever be grown on it, and the power of disposal over a mine is the control of its cooperation in the extraction of all the minerals which can ever be brought to the surface from it. In the same way the ownership of a machine or a bale of cotton is the control of its cooperation in the manufacture of all goods which are produced with its cooperation. The fundamental fallacy implied in all the productivity and use approaches to the problem of interest was that they traced back the phenomenon of interest to these productive services rendered by the factors of production. However, the serviceableness of the factors of production determines the prices paid for them, not interest. These prices exhaust the whole difference between the productivity of a process aided by a definite factor’s cooperation and that of a process lacking this cooperation. The difference between the sum of the prices of the complementary factors of production and the products which emerges even in the absence of changes in the market data concerned, is an outcome of the higher valuation of present goods as compared with future goods. As production goes on, the factors of production are transformed or ripen into present goods of a higher value. This increment is the source of specific proceeds flowing into the hands of the owners of the factors of production, of originary interest.

The owners of the material factors of production—as distinct from the pure entrepreneurs of the imaginary construction of an integration of catallactic functions—harvest two catallactically different items: the prices paid for the productive cooperation of the factors they control on the one hand and interest on the other hand. These Edition: current; Page: [526] two things must not be confused. It is not permissible to refer, in the explanation of interest, to the services rendered by the factors of production in the turning out of products.

Interest is a homogeneous phenomenon. There are no different sources of interest. Interest on durable goods and interest on consumption-credit are like other kinds of interest an outgrowth of the higher valuation of present goods as against future goods.

2: Originary Interest

Originary interest is the ratio of the value assigned to want-satisfaction in the immediate future and the value assigned to want-satisfaction in remote periods of the future. It manifests itself in the market economy in the discount of future goods as against present goods. It is a ratio of commodity prices, not a price in itself. There prevails a tendency toward the equalization of this ratio for all commodities. In the imaginary construction of the evenly rotating economy the rate of originary interest is the same for all commodities.

Originary interest is not “the price paid for the services of capital.”1 The higher productivity of more time-consuming roundabout methods of production which is referred to by Böhm-Bawerk and by some later economists in the explanation of interest does not explain the phenomenon. It is, on the contrary, the phenomenon of originary interest that explains why less time-consuming methods of production are resorted to in spite of the fact that more time-consuming methods would render a higher output per unit of input. Moreover, the phenomenon of originary interest explains why pieces of usable land can be sold and bought at finite prices. If the future services which a piece of land can render were to be valued in the same way in which its present services are valued, no finite price would be high enough to impel its owner to sell it. Land could neither be bought nor sold against definite amounts of money, nor bartered against goods which can render only a finite number of services. Pieces of land would be bartered only against other pieces of land. A superstructure that can yield during a period of ten years an annual revenue of one hundred dollars would be priced (apart from the soil on which it is built) at the beginning of this period at one thousand dollars, at the beginning of the second year at nine hundred dollars, and so on.

Originary interest is not a price determined on the market by the Edition: current; Page: [527] interplay of the demand for and the supply of capital or capital goods. Its height does not depend on the extent of this demand and supply. It is rather the rate of originary interest that determines both the demand for and the supply of capital and capital goods. It determines how much of the available supply of goods is to be devoted to consumption in the immediate future and how much to provision for remoter periods of the future.

People do not save and accumulate capital because there is interest. Interest is neither the impetus to saving nor the reward or the compensation granted for abstaining from immediate consumption. It is the ratio in the mutual valuation of present goods as against future goods.

The loan market does not determine the rate of interest. It adjusts the rate of interest on loans to the rate of originary interest as manifested in the discount of future goods.

Originary interest is a category of human action. It is operative in any valuation of external things and can never disappear. If one day the state of affairs were to return which was actual at the close of the first millennium of the Christian era when some people believed that the ultimate end of all earthly things was impending, men would stop providing for future secular wants. The factors of production would in their eyes become useless and worthless. The discount of future goods as against present goods would not vanish. It would, on the contrary, increase beyond all measure. On the other hand, the fading away of originary interest would mean that people do not care at all for want-satisfaction in nearer periods of the future. It would mean that they prefer to an apple available today, tomorrow, in one year or in ten years, two apples available in a thousand or ten thousand years.

We cannot even think of a world in which originary interest would not exist as an inexorable element in every kind of action. Whether there is or is not division of labor and social cooperation and whether society is organized on the basis of private or of public control of the means of production, originary interest is always present. In a socialist commonwealth its role would not differ from that in the market economy.

Böhm-Bawerk has once for all unmasked the fallacies of the naïve productivity explanations of interest, i.e., of the idea that interest is the expression of the physical productivity of factors of production. However, Böhm-Bawerk has himself based his own theory to some extent on the productivity approach. In referring in his explanation to the technological superiority of more time-consuming, roundabout processes of production, he avoids the crudity of the naïve productivity Edition: current; Page: [528] fallacies. But in fact he returns, although in a subtler form, to the productivity approach. Those later economists who, neglecting the time-preference idea, have stressed exclusively the productivity idea contained in Böhm-Bawerk’s theory cannot help concluding that originary interest must disappear if men were one day to reach a state of affairs in which no further lengthening of the period of production could bring about a further increase in productivity.2 This is, however, utterly wrong. Originary interest cannot disappear as long as there is scarcity and therefore action.

As long as the world is not transformed into a land of Cockaigne, men are faced with scarcity and must act and economize; they are forced to choose between satisfaction in nearer and in remoter periods of the future because neither for the former nor for the latter can full contentment be attained. Then a change in the employment of factors of production which withdraws such factors from their employment for want-satisfaction in the nearer future and devotes them to want-satisfaction in the remoter future must necessarily impair the state of satisfaction in the nearer future and improve it in the remoter future. If we were to assume that this is not the case, we should become embroiled in insoluble contradictions. We may at best think of a state of affairs in which technological knowledge and skill have reached a point beyond which no further progress is possible for mortal men. No new processes increasing the output per unit of input can henceforth be invented. But if we suppose that some factors of production are scarce, we must not assume that all processes which—apart from the time they absorb—are the most productive ones are fully utilized, and that no process rendering a smaller output per unit of input is resorted to merely because of the fact that it produces its final result sooner than other, physically more productive processes. Scarcity of factors of production means that we are in a position to draft plans for the improvement of our well-being the realization of which is unfeasible because of the insufficient quantity of the means available. It is precisely the unfeasibility of such desirable improvements that constitutes the element of scarcity. The reasoning of the modern supporters of the productivity approach is misled by the connotations of Böhm-Bawerk’s term roundabout methods of production and the idea of Edition: current; Page: [529] technological improvement which it suggests. However, if there is scarcity, there must always be an unused technological opportunity to improve the state of well-being by a lengthening of the period of production in some branches of industry, regardless of whether or not the state of technological knowledge has changed. If the means are scarce, if the praxeological correlation of ends and means still exists, there are by logical necessity unsatisfied wants with regard both to nearer and to remoter periods of the future. There are always goods the procurement of which we must forego because the way that leads to their production is too long and would prevent us from satisfying more urgent needs. The fact that we do not provide more amply for the future is the outcome of a weighing of satisfaction in nearer periods of the future against satisfaction in remoter periods of the future. The ratio which is the outcome of this valuation is originary interest.

In such a world of perfect technological knowledge a promoter drafts a plan A according to which a hotel in picturesque, but not easily accessible, mountain districts and the roads leading to it should be built. In examining the practicability of this plan he discovers that the means available are not sufficient for its execution. Calculating the prospects of the profitability of the investment, he comes to the conclusion that the expected proceeds are not great enough to cover the costs of material and labor to be expended and interest on the capital to be invested. He renounces the execution of project A and embarks instead upon the realization of another plan, B. According to plan B the hotel is to be erected in a more easily accessible location which does not offer all the advantages of the picturesque landscape which plan A had selected, but in which it can be built either with lower costs of construction or finished in a shorter time. If no interest on the capital invested were to enter into the calculation, the illusion could arise that the state of the market data—supply of capital goods and the valuations of the public—allows for the execution of plan A. However, the realization of plan A would withdraw scarce factors of production from employments in which they could satisfy wants considered more urgent by the consumers. It would mean a manifest malinvestment, a squandering of the means available.

A lengthening of the period of production can increase the quantity of output per unit of input or produce goods which cannot be produced at all within a shorter period of production. But it is not true that the imputation of the value of this additional wealth to the capital goods required for the lengthening of the period of production generates interest. If one were to assume this, one would relapse Edition: current; Page: [530] into the crassest errors of the productivity approach, irrefutably exploded by Böhm-Bawerk. The contribution of the complementary factors of production to the result of the process is the reason for their being considered as valuable; it explains the prices paid for them and is fully taken into account in the determination of these prices. No residuum is left that is not accounted for and could explain interest.

It has been asserted that in the imaginary construction of the evenly rotating economy no interest would appear.3 However, it can be shown that this assertion is incompatible with the assumptions on which the construction of the evenly rotating economy is based.

We begin with the distinction between two classes of saving: plain saving and capitalist saving. Plain saving is merely the piling up of consumers’ goods for later consumption. Capitalist saving is the accumulation of goods which are designed for an improvement of production processes. The aim of plain saving is later consumption; it is merely postponement of consumption. Sooner or later the goods accumulated will be consumed and nothing will be left. The aim of capitalist saving is first an improvement in the productivity of effort. It accumulates capital goods which are employed for further production and are not merely reserves for later consumption. The boon derived from plain saving is later consumption of the stock not instantly consumed but accumulated for later use. The boon derived from capitalist saving is the increase of the quantity of goods produced or the production of goods which could not be produced at all without its aid. In constructing the image of an evenly rotating (static) economy, economists disregard the process of capital accumulation; the capital goods are given and remain, as, according to the underlying assumptions, no changes occur in the data. There is neither accumulation of new capital through saving, nor consumption of capital available through a surplus of consumption over income, i.e., current production minus the funds required for the maintenance of capital. It is now our task to demonstrate that these assumptions are incompatible with the idea that there is no interest.

There is no need to dwell, in this reasoning, upon plain saving. The objective of plain saving is to provide for a future in which the saver could possibly be less amply supplied than in the present. Yet, one of the fundamental assumptions characterizing the imaginary construction of the evenly rotating economy is that the future does not differ at all from the present, that the actors are fully aware of this fact Edition: current; Page: [531] and act accordingly. Hence, in the frame of this construction, no room is left for the phenomenon of plain saving.

It is different with the fruit of capitalist saving, the accumulated stock of capital goods. There is in the evenly rotating economy neither saving and accumulation of additional capital goods nor eating up of already existing capital goods. Both phenomena would amount to a change in the data and would thus disturb the even rotation of such an imaginary system. Now, the magnitude of saving and capital accumulation in the past—i.e., in the period preceding the establishment of the evenly rotating economy—was adjusted to the height of the rate of interest. If—with the establishment of the conditions of the evenly rotating economy—the owners of the capital goods were no longer to receive any interest, the conditions which were operative in the allocation of the available stocks of goods to the satisfaction of wants in the various periods of the future would be upset. The altered state of affairs requires a new allocation. Also in the evenly rotating economy the difference in the valuation of want-satisfaction in various periods of the future cannot disappear. Also in the frame of this imaginary construction, people will assign a higher value to an apple available today as against an apple available in ten or a hundred years. If the capitalist no longer receives interest, the balance between satisfaction in nearer and remoter periods of the future is disarranged. The fact that a capitalist has maintained his capital at just 100,000 dollars was conditioned by the fact that 100,000 present dollars were equal to 105,000 dollars available twelve months later. These 5,000 dollars were in his eyes sufficient to outweigh the advantages to be expected from an instantaneous consumption of a part of this sum. If interest payments are eliminated, capital consumption ensues.

This is the essential deficiency of the static system as Schumpeter depicts it. It is not sufficient to assume that the capital equipment of such a system has been accumulated in the past, that it is now available to the extent of this previous accumulation and is henceforth unalterably maintained at this level. We must also assign in the frame of this imaginary system a role to the operation of forces which bring about such a maintenance. If one eliminates the capitalist’s role as receiver of interest, one replaces it by the capitalist’s role as consumer of capital. There is no longer any reason why the owner of capital goods should abstain from employing them for consumption. Under the assumptions implied in the imaginary construction of static conditions (the evenly rotating economy) there is no need to keep them in reserve for rainy days. But even if, inconsistently enough, we Edition: current; Page: [532] were to assume that a part of them is devoted to this purpose and therefore withheld from current consumption, at least that part of capital will be consumed which corresponds to the amount that capitalist saving exceeds plain saving.4

If there were no originary interest, capital goods would not be devoted to immediate consumption and capital would not be consumed. On the contrary, under such an unthinkable and unimaginable state of affairs there would be no consumption at all, but only saving, accumulation of capital, and investment. Not the impossible disappearance of originary interest, but the abolition of payment of interest to the owners of capital, would result in capital consumption. The capitalists would consume their capital goods and their capital precisely because there is originary interest and present want-satisfaction is preferred to later satisfaction.

Therefore there cannot be any question of abolishing interest by any institutions, laws, or devices of bank manipulation. He who wants to “abolish” interest will have to induce people to value an apple available in a hundred years no less than a present apple. What can be abolished by laws and decrees is merely the right of the capitalists to receive interest. But such decrees would bring about capital consumption and would very soon throw mankind back into the original state of natural poverty.

3: The Height of Interest Rates

In plain saving and in the capitalist saving of isolated economic actors the difference in the valuation of want-satisfaction in various periods of the future manifests itself in the extent to which people provide in a more ample way for nearer than for remoter periods of the future. Under the conditions of a market economy the rate of originary interest is, provided the assumptions involved in the imaginary construction of the evenly rotating economy are present, equal to the ratio of a definite amount of money available today and the amount available at a later date which is considered as its equivalent.

The rate of originary interest directs the investment activities of the entrepreneurs. It determines the length of waiting time and of the period of production in every branch of industry.

People often raise the question of which rate of interest, a “high” or a “low,” stimulates saving and capital accumulation more and which less. The question makes no sense. The lower the discount attached to future goods is, the lower is the rate of originary interest. People Edition: current; Page: [533] do not save more because the rate of originary interest rises, and the rate of originary interest does not drop on account of an increase in the amount of saving. Changes in the originary rates of interest and in the amount of saving are—other things, especially the institutional conditions, being equal—two aspects of the same phenomenon. The disappearance of originary interest would be tantamount to the disappearance of consumption. The increase of originary interest beyond all measure would be tantamount to the disappearance of saving and any provision for the future.

The quantity of the available supply of capital goods influences neither the rate of originary interest nor the amount of further saving. Even the most plentiful supply of capital need not necessarily bring about either a lowering of the rate of originary interest or a drop in the propensity to save. The increase in capital accumulation and the per capita quota of capital invested which is a characteristic mark of economically advanced nations does not necessarily either lower the rate of originary interest or weaken the propensity of individuals to make additional savings. People are, in dealing with these problems, for the most part misled by comparing merely the market rates of interest as they are determined on the loan market. However, these gross rates are not merely expressive of the height of originary interest. They contain, as will be shown later, other elements besides, the effect of which accounts for the fact that the gross rates are as a rule higher in poorer countries than in richer ones.

It is generally asserted that, other things being equal, the better individuals are supplied for the immediate future, the better they provide for wants for the remoter future. Consequently, it is said, the amount of total saving and capital accumulation within an economic system depends on the arrangement of the population into groups of different income levels. In a society with approximate income equality there is, it is said, less saving than in a society in which there is more inequality. There is a grain of truth in such observations. However, they are statements about psychological facts and as such lack the universal validity and necessity inherent in praxeological statements. Moreover, the other things the equality of which they presuppose comprehend the various individuals’ valuations, their subjective value judgment in weighing the pros and cons of immediate consumption and of postponement of consumption. There are certainly many individuals whose behavior they describe correctly, but there also are other individuals who act in a different way. The French peasants, although for the most part people of moderate wealth and income, were in the nineteenth century widely known Edition: current; Page: [534] for their parsimonious habits, while wealthy members of the aristocracy and heirs of huge fortunes amassed in commerce and industry were no less renowned for their profligacy.

It is therefore impossible to formulate any praxeological theorem concerning the relation of the amount of capital available in the whole nation or to individual people on the one hand and the amount of saving or capital consumption and the height of the originary rate of interest on the other hand. The allocation of scarce resources to want-satisfaction in various periods of the future is determined by value judgments and indirectly by all those factors which constitute the individuality of the acting man.

4: Originary Interest in the Changing Economy

So far we have dealt with the problem of originary interest under certain assumptions: that the turnover of goods is effected by the employment of neutral money; that saving, capital accumulation, and the determination of interest rates are not hampered by institutional obstacles; and that the whole economic process goes on in the frame of an evenly rotating economy. We shall drop the first two of these assumptions in the following chapter. Now we want to deal with originary interest in a changing economy.

He who wants to provide for the satisfaction of future needs must correctly anticipate these needs. If he fails in this understanding of the future, his provision will prove less satisfactory or totally futile. There is no such thing as an abstract saving that could provide for all classes of want-satisfaction and would be neutral with regard to changes occurring in conditions and valuations. Originary interest can therefore in the changing economy never appear in a pure unalloyed form. It is only in the imaginary construction of the evenly rotating economy that the mere passing of time matures originary interest; in the passage of time and with the progress of the process of production more and more value accrues, as it were, to the complementary factors of production; with the termination of the process of production the lapse of time has generated in the price of the product the full quota of originary interest. In the changing economy during the period of production there also arise synchronously other changes in valuations. Some goods are valued higher than previously, some lower. These alterations are the source from which entrepreneurial profits and losses stem. Only those entrepreneurs who in their planning have correctly anticipated the future state of the market are in a position to reap, in selling the products, an excess over the costs of production (inclusive of net originary interest) expended. An entrepreneur Edition: current; Page: [535] who has failed in his speculative understanding of the future can sell his products, if at all, only at prices which do not cover completely his expenditures plus originary interest on the capital invested.

Like entrepreneurial profit and loss, interest is not a price, but a magnitude which is to be disengaged by a particular mode of computation from the price of the products of successful business operations. The gross difference between the price at which a commodity is sold and the costs expended in its production (exclusive of interest on the capital invested) was called profit in the terminology of British classical economics.5 Modern economics conceives this magnitude as a complex of catallactically disparate items. The excess of gross receipts over expenditures which the classical economists called profit includes the price for the entrepreneur’s own labor employed in the process of production, interest on the capital invested, and finally entrepreneurial profit proper. If such an excess has not been reaped at all in the sale of the products, the entrepreneur not only fails to get profit proper, he receives neither an equivalent for the market value of the labor he has contributed nor interest on the capital invested.

The breaking down of gross profit (in the classical sense of the term) into managerial wages, interest, and entrepreneurial profit is not merely a device of economic theory. It developed, with progressing perfection in business practices of accountancy and calculation, in the field of commercial routine independently of the reasoning of the economists. The judicious and sensible businessman does not attach practical significance to the confused and garbled concept of profit as employed by the classical economists. His notion of costs of production includes the potential market price of his own services contributed, the interest paid on capital borrowed, and the potential interest he could earn, according to the conditions of the market, on his own capital invested in the enterprise by lending it to other people. Only the excess of proceeds over the costs so calculated is in his eyes entrepreneurial profit.6

The precipitation of entrepreneurial wages from the complex of all the other items included in the profit concept of classical economics presents no particular problem. It is more difficult to sunder entrepreneurial profit from originary interest. In the changing economy Edition: current; Page: [536] interest stipulated in loan contracts is always a gross magnitude out of which the pure rate of originary interest must be computed by a particular process of computation and analytical repartition. It has been shown already that in every act of lending, even apart from the problem of changes in the monetary unit’s purchasing power, there is an element of entrepreneurial venture. The granting of credit is necessarily always an entrepreneurial speculation which can possibly result in failure and the loss of a part or of the total amount lent. Every interest stipulated and paid in loans includes not only originary interest but also entrepreneurial profit.

This fact for a long time misled the attempts to construct a satisfactory theory of interest. It was only the elaboration of the imaginary construction of the evenly rotating economy that made it possible to distinguish precisely between originary interest and entrepreneurial profit and loss.

5: The Computation of Interest

Originary interest is the outgrowth of valuations unceasingly fluctuating and changing. It fluctuates and changes with them. The custom of computing interest pro anno is merely commercial usage and a convenient rule of reckoning. It does not affect the height of the interest rates as determined by the market.

The activities of the entrepreneurs tend toward the establishment of a uniform rate of originary interest in the whole market economy. If there turns up in one sector of the market a margin between the prices of present goods and those of future goods which deviates from the margin prevailing in other sectors, a trend toward equalization is brought about by the striving of businessmen to enter those sectors in which this margin is higher and to avoid those in which it is lower. The final rate of originary interest is the same in all parts of the market of the evenly rotating economy.

The valuations resulting in the emergence of originary interest prefer satisfaction in a nearer period of the future to satisfaction of the same kind and extent in a remoter period of the future. Nothing would justify the assumption that this discounting of satisfaction in remoter periods progresses continuously and evenly. If we were to assume this, we would imply that the period of provision is infinite. However, the mere fact that individuals differ in their provision for future needs and that even to the most provident actor provision beyond a definite period appears supererogatory, forbids us to think of the period of provision as infinite.

The usages of the loan market must not mislead us. It is customary Edition: current; Page: [537] to stipulate a uniform rate of interest for the whole duration of a loan contract7 and to apply a uniform rate in computing compound interest. The real determination of interest rates is independent of these and other arithmetical devices of interest computation. If the rate of interest is unalterably fixed by contract for a period of time, intervening changes in the market rate of interest are reflected in corresponding changes in the prices paid for the principal, due allowance being made for the fact that the amount of principal to be paid back at the maturity of the loan is unalterably stipulated. It does not affect the result whether one calculates with an unchanging rate of interest and changing prices of the principal or with changing interest rates and an unchanging amount of the principal, or with changes in both magnitudes.

The terms of a loan contract are not independent of the stipulated duration of the loan. Not only because those components of the gross rate of market interest which made it deviate from the rate of originary interest are affected by differences in the duration of the loan, but also on account of factors which bring about changes in the rate of originary interest, loan contracts are valued and appraised differently according to the duration of the loan stipulated.

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CHAPTER 20: Interest, Credit Expansion, and the Trade Cycle

1: The Problems

In the market economy in which all acts of interpersonal exchange are performed by the intermediary of money, the category of originary interest manifests itself primarily in the interest on money loans.

It has been pointed out already that in the imaginary construction of the evenly rotating economy the rate of originary interest is uniform. There prevails in the whole system only one rate of interest. The rate of interest on loans coincides with the rate of originary interest as manifested in the ratio between prices of present and of future goods. We may call this rate the neutral rate of interest.

The evenly rotating economy presupposes neutral money. As money can never be neutral, special problems arise.

If the money relation—i.e., the ratio between the demand for and the supply of money for cash holding—changes, all prices of goods and services are affected. These changes, however, do not affect the prices of the various goods and services at the same time and to the same extent. The resulting modifications in the wealth and income of various individuals can also alter the data determining the height of originary interest. The final state of the rate of originary interest to the establishment of which the system tends after the appearance of changes in the money relation, is no longer that final state toward which it had tended before. Thus, the driving force of money has the power to bring about lasting changes in the final rate of originary interest and neutral interest.

Then there is a second, even more momentous, problem which, of course, may also be looked upon as another aspect of the same problem. Changes in the money relation may under certain circumstances first affect the loan market in which the demand for and the supply of loans influence the market rate of interest on loans, which we may call the gross money (or market) rate of interest. Can such changes in the gross money rate cause the net rate of interest included in it to deviate lastingly from the height which corresponds to the Edition: current; Page: [539] rate of originary interest, i.e., the difference between the valuation of present and future goods? Can events on the loan market partially or totally eliminate originary interest? No economist will hesitate to answer these questions in the negative. But then a further problem arises: How does the interplay of the market factors readjust the gross money rate to the height conditioned by the rate of originary interest?

These are great problems. These were the problems economists tried to solve in discussing banking, fiduciary media and circulation credit, credit expansion, gratuitousness or nongratuitousness of credit, the cyclical movements of trade, and all other problems of indirect exchange.

2: The Entrepreneurial Component in the Gross Market Rate of Interest

The market rates of interest on loans are not pure interest rates. Among the components contributing to their determination there are also elements which are not interest. The moneylender is always an entrepreneur. Every grant of credit is a speculative entrepreneurial venture, the success or failure of which is uncertain. The lender is always faced with the possibility that he may lose a part or the whole of the principal lent. His appraisal of this danger determines his conduct in bargaining with the prospective debtor about the terms of the contract.

There can never be perfect safety either in moneylending or in other classes of credit transactions and deferred payments. Debtors, guarantors, and warrantors may become insolvent; collateral and mortgages may become worthless. The creditor is always a virtual partner of the debtor or a virtual owner of the pledged and mortgaged property. He can be affected by changes in the market data concerning them. He has linked his fate with that of the debtor or with the changes occurring in the price of the collateral. Capital as such does not bear interest; it must be well employed and invested not only in order to yield interest; but also lest it disappear entirely. The dictum pecunia pecuniam parere non potest (money cannot beget money) is meaningful in this sense, which, of course, differs radically from the sense which ancient and medieval philosophers attached to it. Gross interest can be reaped only by creditors who have been successful in their lending. If they earn any net interest at all, it is included in a yield which contains more than merely net interest. Net interest is a magnitude which only analytical thinking can extract from the gross proceeds of the creditor.

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The entrepreneurial component included in the creditor’s gross proceeds is determined by all those factors which are operative in every entrepreneurial venture. It is, moreover, codetermined by the legal and institutional setting. The contracts which place the debtor and his fortune or the collateral as a buffer between the creditor and the disastrous consequences of malinvestment of the capital lent, are conditioned by laws and institutions. The creditor is less exposed to loss and failure than the debtor only in so far as this legal and institutional framework makes it possible for him to enforce his claims against refractory debtors. There is, however, no need for economics to enter into a detailed scrutiny of the legal aspects involved in bonds and debentures, preferred stock, mortgages, and other kinds of credit transactions.

The entrepreneurial component is present in all species of loans. It is customary to distinguish between consumption or personal loans on the one hand, and productive or business loans on the other. The characteristic mark of the former class is that it enables the borrower to spend expected future proceeds. In acquiring a claim to a share in these future proceeds, the lender becomes virtually an entrepreneur, as in acquiring a claim to a share in the future proceeds of a business. The particular uncertainty of the outcome of his lending consists in the uncertainty about these future proceeds.

It is furthermore customary to distinguish between private and public loans, i.e., loans to governments and subdivisions of governments. The particular uncertainty inherent in such loans concerns the life of secular power. Empires may crumble and governments may be overthrown by revolutionaries who are not prepared to assume responsibility for the debts contracted by their predecessors. That there is, besides, something basically vicious in all kinds of long-term government debts, has been pointed out already.1

Over all species of deferred payments hangs, like the sword of Damocles, the danger of government interference. Public opinion has always been biased against creditors. It identifies creditors with the idle rich and debtors with the industrious poor. It abhors the former as ruthless exploiters and pities the latter as innocent victims of oppression. It considers government action designed to curtail the claims of the creditors as measures extremely beneficial to the immense majority at the expense of a small minority of hard-boiled usurers. It did not notice at all that nineteenth-century capitalist innovations have wholly changed the composition of the classes of creditors and debtors. In the days of Solon the Athenian, of ancient Edition: current; Page: [541] Rome’s agrarian laws, and of the Middle Ages, the creditors were by and large the rich and the debtors the poor. But in this age of bonds and debentures, mortgage banks, saving banks, life insurance policies, and social security benefits, the masses of people with more moderate income are rather themselves creditors. On the other hand, the rich, in their capacity as owners of common stock, of plants, farms, and real estate, are more often debtors than creditors. In asking for the expropriation of creditors, the masses are unwittingly attacking their own particular interests.

With public opinion in this state, the creditor’s unfavorable chance of being harmed by anticreditor measures is not balanced by a favorable chance of being privileged by antidebtor measures. This unbalance would bring about a unilateral tendency toward a rise of the entrepreneurial component contained in the gross rate of interest if the political danger were limited to the loan market, and would not in the same way affect today all kinds of private ownership of the means of production. As things are in our day, no kind of investment is safe against the political dangers of anticapitalistic measures. A capitalist cannot reduce the vulnerability of his wealth by preferring direct investment in business to lending his capital to business or to the government.

The political risks involved in moneylending do not affect the height of originary interest; they affect the entrepreneurial component included in the gross market rate. In the extreme case—i.e., in a situation in which the impending nullification of all contracts concerning deferred payments is expected—they would cause the entrepreneurial component to increase beyond all measure.2

3: The Price Premium as a Component of the Gross Market Rate of Interest

Money is neutral if the cash-induced changes in the monetary unit’s purchasing power affect at the same time and to the same extent the prices of all commodities and services. With neutral money, a neutral rate of interest would be conceivable, provided there were no deferred payments. If there are deferred payments and if we disregard the entrepreneurial position of the creditor and the ensuing entrepreneurial component in the gross rate of interest, we must furthermore assume that the eventuality of future changes in purchasing Edition: current; Page: [542] power is taken into account in stipulating the terms of the contract. The principal is to be multiplied periodically by the index number and thus to be increased or decreased in accordance with the changes that have come to pass in purchasing power. With the adjustment of the principal, the amount from which the rate of interest is to be calculated changes too. Thus, this rate is a neutral rate of interest.

With neutral money, neutralization of the rate of interest could also be attained by another stipulation, provided the parties are in a position to anticipate correctly the future changes in purchasing power. They could stipulate a gross rate of interest containing an allowance for such changes, a percentile addendum to, or subtrahendum from, the rate of originary interest. We may call this allowance the—positive or negative—price premium. In the case of a quickly progressing deflation, the negative price premium could not only swallow the whole rate of originary interest, but even reverse the gross rate into a minus quantity, an amount charged to the creditor’s account. If the price premium is correctly calculated, neither the creditor’s nor the debtor’s position is affected by intervening changes in purchasing power. The rate of interest is neutral.

However, all these assumptions are not only imaginary, they cannot even hypothetically be thought of without contradiction. In the changing economy, the rate of interest can never be neutral. In the changing economy, there is no uniform rate of originary interest; there only prevails a tendency toward the establishment of such uniformity. Before the final state of originary interest is attained, new changes in the data emerge which divert anew the movement of interest rates toward a new final state. Where everything is unceasingly in flux, no neutral rate of interest can be established.

In the world of reality all prices are fluctuating and acting men are forced to take full account of these changes. Entrepreneurs embark upon business ventures and capitalists change their investments only because they anticipate such changes and want to profit from them. The market economy is essentially characterized as a social system in which there prevails an incessant urge toward improvement. The most provident and enterprising individuals are driven to earn profit by readjusting again and again the arrangement of production activities so as to fill in the best possible way the needs of the consumers, both those needs of which the consumers themselves are already aware and those latent needs of the satisfaction of which they have not yet thought themselves. These speculative ventures of the promoters revolutionize afresh each day the structure of prices and thereby also the height of the gross market rate of interest.

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He who expects a rise in certain prices enters the loan market as a borrower and is ready to allow a higher gross rate of interest than he would allow if he were to expect a less momentous rise in prices or no rise at all. On the other hand, the lender, if he himself expects a rise in prices, grants loans only if the gross rate is higher than it would be under a state of the market in which less momentous or no upward changes in prices are anticipated. The borrower is not deterred by a higher rate if his project seems to offer such good chances that it can afford higher costs. The lender would abstain from lending and would himself enter the market as an entrepreneur and bidder for commodities and services if the gross rate of interest were not to compensate him for the profits he could reap this way. The expectation of rising prices thus has the tendency to make the gross rate of interest rise, while the expectation of dropping prices makes it drop. If the expected changes in the price structure concern only a limited group of commodities and services, and are counterbalanced by the expectation of an opposite change in the prices of other goods, as is the case in the absence of changes in the money relation, the two opposite trends by and large counterpoise each other. But if the money relation is sensibly altered and a general rise or fall in the prices of all commodities and services is expected, one tendency carries on. A positive or negative price premium emerges in all deals concerning deferred payments.3

The role of the price premium in the changing economy is different from that we ascribed to it in the hypothetical and unrealizable scheme developed above. It can never entirely remove, even as far as credit operations alone are concerned, the effects of changes in the money relation; it can never make interest rates neutral. It cannot alter the fact that money is essentially equipped with a driving force of its own. Even if all actors were to know correctly and completely the quantitative data concerning the changes in the supply of money (in the broader sense) in the whole economic system, the dates on which such changes were to occur and what individuals were to be first affected by them, they would not be in a position to know beforehand whether and to what extent the demand for money for cash holding would change and in what temporal sequence and to what extent the prices of the various commodities would change. The price premium could counterpoise the effects of changes in the money relation upon the substantial importance and the economic significance of credit contracts only if its appearance were to precede the occurrence of the price changes generated by the alteration in the money relation. It would have to be the result of a reasoning by virtue Edition: current; Page: [544] of which the actors try to compute in advance the date and the extent of such price changes with regard to all commodities and services which directly or indirectly count for their own state of satisfaction. However, such computations cannot be established because their performance would require a perfect knowledge of future conditions and valuations.

The emergence of the price premium is not the product of an arithmetical operation which could provide reliable knowledge and eliminate the uncertainty concerning the future. It is the outcome of the promoters’ understanding of the future and their calculations based on such an understanding. It comes into existence step by step as soon as first a few and then successively more and more actors become aware of the fact that the market is faced with cash-induced changes in the money relation and consequently with a trend oriented in a definite direction. Only when people begin to buy or to sell in order to take advantage of this trend, does the price premium come into existence.

It is necessary to realize that the price premium is the outgrowth of speculations anticipating changes in the money relation. What induces it, in the case of the expectation that an inflationary trend will keep on going, is already the first sign of that phenomenon which later, when it becomes general, is called “flight into real values” and finally produces the crack-up boom and the crash of the monetary system concerned. As in every case of the understanding of future developments, it is possible that the speculators may err, that the inflationary or deflationary movement will be stopped or slowed down, and that prices will differ from what they expected.

The increased propensity to buy or to sell, which generates the price premium, affects as a rule short-term loans sooner and to a greater extent than long-term loans. As far as this is the case, the price premium affects the market for short-term loans first, and only later, by virtue of the concatenation of all parts of the market, also the market for long-term loans. However, there are instances in which a price premium in long-term loans appears independently of what is going on with regard to short-term loans. This was especially the case in international lending in the days in which there was still a live international capital market. It happened occasionally that lenders were confident with regard to the short-term development of a foreign country’s national currency; in short-term loans stipulated in this currency there was no price premium at all or only a slight one. But the appraisal of the long-term aspects of the currency concerned was less favorable, and consequently in long-term contracts a Edition: current; Page: [545] considerable price premium was taken into account. The result was that long-term loans stipulated in this currency could be floated only at a higher rate than the same debtor’s loans stipulated in terms of gold or a foreign currency.

We have shown one reason why the price premium can at best practically deaden, but never eliminate entirely, the repercussions of cash-induced changes in the money relation upon the content of credit transactions. (A second reason will be dealt with in the next section.) The price premium always lags behind the changes in purchasing power because what generates it is not the change in the supply of money (in the broader sense), but the—necessarily later-occurring—effects of these changes upon the price structure. Only in the final state of a ceaseless inflation do things become different. The panic of the currency catastrophe, the crack-up boom, is not only characterized by a tendency for prices to rise beyond all measure, but also by a rise beyond all measure of the positive price premium. No gross rate of interest, however great, appears to a prospective lender high enough to compensate for the losses expected from the progressing drop in the monetary unit’s purchasing power. He abstains from lending and prefers to buy himself “real” goods. The loan market comes to a stand-still.

4: The Loan Market

The gross rates of interest as determined on the loan market are not uniform. The entrepreneurial component which they always include varies according to the peculiar characteristics of the specific deal. It is one of the most serious shortcomings of all historical and statistical studies devoted to the movement of interest rates that they neglect this factor. It is useless to arrange data concerning interest rates of the open market or the discount rates of the central banks in time series. The various data available for the construction of such time series are incommensur